Remember when some were calling for the euro to hit parity with the dollar? It wasn’t that long ago, back when the euro broke below $1.20.
Then in early June, Iran’s Mahmoud Ahmadinejad caved in, with his nation announcing they were selling their 45 billion euros for dollars and gold. Whoops. Since then the euro rallied hard, and just broke $1.29.
And if you’re not quite sold on the idea that Ahmadinejad gave the market a clear contrarian signal, then there were probably other reasons for the euro to rally as well. Mainly, markets became optimistic about Europe stress-testing its banks, thus adding a shred of transparency to its financial situation. The U.S. was also hit by a wave of economic data points missing expectations, and as is the case with currencies it’s not so much how bad your nation is, but how bad you are relative to your peers. Thus Europe had a respite from bad news while focus returned to America’s problems.
So now what? Well, Morgan Stanley’s Stephen Hull and Ron Levin think the rally has run its course.
Overall, with the euro now trading rich to fair value against the dollar and on a trade-weighted basis, we think many of the factors that have undermined the euro so far in 2010 are likely to weigh on it again in the second half. Indeed, if there are growing risks that US growth disappoints, then the same is likely to happen to the Eurozone, especially as fiscal policy is being tightened in Europe.
Our analysis of Eurozone capital flows through the broad basic balance of payments reveals that the demand for euros has weakened significantly so far this year and is much weaker than we anticipated with a lack on bond inflows being the primary factor (Exhibit 5). A weaker BBoP combined with evidence from the IMF COFER data that central banks were very big buyers of euros (USD 160bn) in Q1 as they kept their allocations of euros stable suggests to us that the euro is unlikely to rally much further (Exhibit 6).
Our proprietary positioning indicator (which we are going to release for all currencies shortly) reveals that the market has probably cleared out its short euro position over recent weeks (Exhibit 7).
They’ve now doubled their short against the euro to 20% of their model portfolio, though with a stop-loss set at $1.34. Their target for the EUR/USD is set at a whopping $1.18.
(Via Morgan Stanley, FX Pulse, Stephen Hull, 15 July 2010)
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