Bearish case for EUR/USD? | The5ers Forex Blog

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Up to this point, the two economies experienced similar routes, similar policies, and similar outcomes. As soon as the goal of central banks shifted from sustaining a global crisis to returning to price stability, it was reasonable to believe that both the FED and the ECB would have switched to a restrictive monetary policy. Operating in tandem, as they did previously.\xa0 That is sort of what happened, but this time, structural differences between the two

An article by McKinsey and Co. came out in late 2020, which breaks down in detail the damage done by shutdowns to SMEs. Interestingly, loss of earnings growth aside, 1\xa0 out of 10 of the SMEs surveyed reported that they feared they could have filed for bankruptcy within the following six months.

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Core PCE, the FED’s favorite inflation measure, ticked higher in October. Source: Bloomberg. Markets have started to understand that rates will stay higher for longer than expected, and as a consequence of very positive economic data, the yield curve has started to flatten, with the long end of the treasury leading the process. Higher rates on the long end will be a major driver of inflows into the dollar.

Through careful observation of yield movements, it becomes obvious that the ECB is manipulating spreads through the PEPP purchases; hence, some European treasury yields cannot be treated as a market price. Periphery yields do not offer any serious risk premium over German bunds, which are usually used as a reference. Italian, Spanish, and Greek 10-year yields appear too low. Investors can get equal, if not better, returns in the US or the UK debt markets, which are far more appealing.

If the energy crisis has definitely had an impact on manufacturing, a clear sign of broader underlying weakness can be found in services, whose numbers are plummeting too. This means that no sector has been spared, weakness has become endemic, and a recession starts to be a possibility. As previously explained, this is due to the uncompetitive position of

Essentially, the markets priced in a hawkish ECB, a dovish FED, and a weaker American economy, which had more chance of going into a recession than Europe. None of this made any sense. The amount of euro bullishness in speculative capital movements went through the roof and brought the euro back to 1.12. The truth has started to unfold in the past couple of months, and hedge funds have started to cut their long exposure on the Euro and their shorts on the greenback. The US treasury market has been selling off, as market participants\xa0have started to understand that rates are going to stay higher for longer than expected, and the yield curve started to normalize. The long end of the treasury, of course, has been leading the process. This will keep pushing the Dollar higher. It will probably put some pressure on the European rates too, but with PEPP investments continuing for more than a\xa0 year, the ECB will probably keep yields under control, thus driving foreign investors out of the sovereign debt market and out of the euro.

It is safe to say that the lockdown policy was devastating for the European economy. Closing down national economies was detrimental to small businesses, and many of them had to shut down for good. Politicians thought that with ever-lasting fiscal stimulus, they could have avoided any harm; they didn’t realize how hard they were punching in the face of the already weak economic environment they had been elected to manage.

First and foremost, I want to focus on the economic uncertainties of Europe, as they are probably the most important variable in my thesis and the most misinterpreted aspect by the markets.

I believe that given these circumstances, an intense economic slowdown in Europe was inevitable after the ECB pivot. The war in Eastern Europe, which exploded in early 2022,\xa0 added fuel to the fire and highlighted another important issue related to European policy, energy. The EU doesn’t have a harmonized energy policy, and every country member is mostly free to provide for itself. We can say that most members have always imported energy from abroad and rarely produced it on national soil, with the exception of France and its nuclear power plants. The Eurozone is a net energy importer. That makes the continent more sensitive to energy prices.

It can be seen that for a growth model based on manufacturing and export and an economic structure whose foundation is small-medium companies, which are already going through difficulties, an inflationary environment and consequent higher interest rates are absolute poison. The competitive position of Europe had already been deteriorating before COVID, then lockdowns were another huge hit, and now higher interest rates are battering what has remained. Companies are facing ever-increasing production costs, higher costs of money, and an appreciating currency that is making exports harder to do. Almost every country reported a deterioration in the trade balance. Not only is this point about supply and demand for the Euro, but it is also about economic output. The EU used to run a big trade surplus before the pandemic, which is now gone.

The global economy has experienced numerous shocks in the past few years. A global pandemic, a war in eastern Europe, and multiple bank failures, just to name a few of the major events that have shaped the world after 2020.\xa0 Unexpected crises, such as the events just mentioned, require rapid action from institutions. Governments and Central banks answered. Whether these institutions have been acting correctly or not is hard to say, but it is worth analyzing how events have been unfolding in the two major Western economies, the United States, and the Euro-Area. In this article, I will attempt to explain the reasoning that convinced me to adopt a bearish stance on EUR/USD in 2021, and why I maintain the same bias on the cross. I am no financial advisor, and this article is the pure product of my personal opinions. I hope that you may find my thoughts interesting.

American and Asian massive conglomerates became harder and harder for European companies. Small to medium enterprises suffer from a lack of funds for R&D, low wages, and low productivity levels. They are more subject to economic fluctuations, and it doesn’t take much of a decline in economic output to bring many small businesses down.

Sovereign debt, in certain European countries, runs at very dangerous levels, which are not sustainable. This is something that Europe has been dealing with for some time, yet no solution has been found. The trend of foreign investors fleeing from periphery debt and bond yields going up started decades ago and apparently culminated in 2011-2012. The peak of the crisis in the early 2010s was just apparent, as no long-term solution was really found, and the problem was just pushed under the carpet. The ECB committed to relentless bond buying, and Greece aside, the incriminated countries weren’t really forced to make any structural reform to bring their debt levels down. Allowing periphery countries to run such high debt-to-GDP ratios in such a low-growth environment was a very unwise move. In a\xa0 market environment with rates near zero, QE, and low inflation, it can appear sustainable when in reality, it is not.

Consequently, a final point should be made about rate movements in the United States. As previously stated, the yield curve has been inverted for the past year; markets were expecting a recession and a premature end to inflation. The first cuts were expected as soon as 2023. Both expectations were completely off target. Markets kept shifting their expectations of rate cuts meeting after meeting, from June to the end of 2023.

The COVID crisis caught most institutions all around the world unprepared. Uncertainty was reigning supreme. In the Western world, governments decided to shut down national economies, in a desperate attempt to prevent the virus from circulating uncontrolled, and to massively subsidize businesses and citizens in order not to depress economic confidence.\xa0 That led to massive government deficit spending and relentless money printing. The\xa0 American debt to GDP ratio shot up from just above 100% to more than 130%. A symmetrical strategy was employed in the EU, where general rules of fiscal responsibility have been temporarily suspended. Both the FED and the ECB embraced an ultra-loose monetary policy, by cutting rates to zero and by expanding their balance sheets through massive purchases of securities.

As a consequence of the facts explored so far, it is reasonable to be bearish on EUR/USD.\xa0 The EU is suffering from a serious economic slump, which can only be buffered by structural reforms or a weaker currency. The absence of risk premium on European yields drives investors out of the euro. Inflation still stands above the ECB’s target, and that puts the ECB in a tough spot, as raising rates has become more dangerous given the recessionary environment and the precarious fiscal situation. On the other hand, the United States has been showing far greater economic resilience. Consequently, interest rates can stay “higher for longer” more comfortably.

Source: Bloomberg survey of economists conducted Oct. 13-18

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EU’s Economic Uncertainties

So, if monetary policy is set to be steady, the Dollar keeps its advantage over the euro. If we take into account the future course of rates policy, there is a chance that wrong expectations are still present, as economic trends are pointing to a different story than the one markets have believed so far. The ECB clearly has more reasons to embark on an eventual pivot.

As shown previously, markets priced in a higher chance of a recession in the US than in\xa0 Europe, which was a completely misleading idea. For many reasons, the US enjoys bigger competitive advantages, and it was clear that its economic structure would have been less damaged by the current economic trends. The larger size of the American enterprises allowed them to navigate the lockdowns (which in any case were less restrictive than in\xa0 Europe) with smaller drawdowns, and consumer spending remained a huge driver of growth,\xa0 as very flexible wages have been rising in order to keep up with inflation. Unemployment still stands at all-time lows. Most importantly, technological innovations have been a huge tailwind that increased profits and attracted money and investors. The US is in the lead for what concerns the AI revolution, which is going to impact productivity meaningfully. Europe seems way less exposed to these new trends.

economies would have rendered the decoupling of the two monetary policies inevitable. This is the base thesis upon which I based my bearish case scenario for EUR/USD.

Source: Eurostat

Let’s dive deeper into EUR/USD’s recent story. The euro dropped below parity in September 2022. Halfway through 2021, markets started to discount a very aggressive hawkish FED.\xa0 The FED started to raise rates convincingly, and the euro collapsed. In the meantime, inflation in Europe was running hot, while in the States, it started to cool down. The ECB then stepped on the gas. In October 2022, it started to cut its balance sheet and raise rates faster. The Euro started to recover. The USD depreciated against the euro for almost a year from that moment. At that point, a rebound was due, considering that EUR/USD went from\xa0 1.22 to 0.96. What I argue is that this consequent euro rally was based on false premises and brought the euro back into overvaluation.

As long as the two central banks keep monetary policy steady, it is clear that the greenback is going to have an advantage in terms of interest rate differential. However, most of the speculative capital movement in currencies, as in financial markets in general, is driven by expectations. Despite the evidence that economic data have presented, there could still be flawed expectations priced in terms of future monetary policy.

Latest CPI data. Source: Bloomberg.

Even though it was reasonable to believe that the US would have shown greater economic resilience, this kind of output is still very impressive. The Federal funds rate increased from 0\xa0 to 5.25%-5.5% in less than two years, and the economy has shown very modest cooling. As previously said, this has huge implications in terms of monetary policy, as clearly, the two economies are now experiencing different paths. It is unclear how much this American strength goes on, but as far as this EUR/USD trade goes, it is not strictly important, as it is obvious that Europe is going to be the worst performer overall going forward.

The future course of interest rates, in this case, is strictly tied to the level of economic output and the future course of inflation. The course of events, linked to these two aspects, has been rather nebulous and markets might have misinterpreted it in the past year. They failed to recognize the influence of some important factors on the two economies, such as their post-pandemic outlook and fiscal policy, especially in Europe. In my analysis, I shall try to explain my point of view on all these topics and depict why I am bearish on the euro and long on the dollar.

EUR/USD, A Brief Summary