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Euro Short Covering Underway, but Long-term Outlook Still Bearish

Euro Short Covering Underway, but Long-term Outlook Still Bearish

Christopher Vecchio, CFA, Senior Strategist
Euro Short Covering Underway, but Long-term Outlook Still Bearish

Fundamental Forecast for Euro:Neutral

- The stage was set for EURUSD short covering, and the Fed decimated the US Dollar mid-week.

- The retail crowd’s penchant for selling the Euro is proving to be a reliable contrarian indicator.

- Have a bullish (or bearish) bias on the Euro, but don’t know which pair to use? Use a Euro currency basket.

The FOMC meeting proved to be the powder keg it was hyped up to be, helping spark a massive EURUSD short covering rally that produced the biggest single-day rally in over three-years. EURUSD closed the week up +3.00% at $1.0814, after setting fresh yearly lows at $1.0458 on Monday. With a build in Euro short positioning among future market speculators ahead of the FOMC meeting – to 193.8K net-short contracts for the week ended March 17 – there’s been and remains plenty of tinder to keep EURUSD elevated in the near-future.

The rapid build in short positioning ahead of the FOMC meeting brought the market back in line with the extreme positioning seen in early-February (196.3K net-short contracts for the week ended February 3), right before a month-long consolidation developed in EURUSD. Now that the Fed has essentially changed the goalposts on raising rates – pushing the likelihood of the first rate hike for either October or December, per the federal funds futures contracts – the weak data coming out of the US provides good reason for the massive net-long US Dollar position to be unwound.

Even if the short EURUSD position is unwound, the Euro viewed in isolation is still a weak currency fundamentally. Bond prices across the region continue to rise, with yields in Germany negative out to 7 years right now. The 5-year German bund yield closed the week at -0.11%, while 5Y5Y inflation expectations came in at +1.760%; as yields fall and inflation expectations rise, Euro-Zone based investors will be forced to seek yield outside the region, thereby exchanging Euros for foreign currencies in order to invest in higher yielding foreign assets.

Over the next few weeks, EURUSD may not offer the best opportunity for seeing weakness in the Euro; that could go to the commodity currencies, which have had historically strong end-of-March trading sessions per QE-era seasonal studies. Allowing more time for the market to recalibrate to the Fed’s new goalposts and the US economy to move through early-Q1 data (which has been deplorable, even recession-like) will most likely be the best path forward in EURUSD. –CV

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