Where is the Euro Headed?Despite unprecedented rate hikes up to 450 basis points over the last 12 months the Euro has lost ground to the US Dollar for the last nine straight weeks. As a result, the Eurozone interest rates are historical highs.
Currencies desire nothing more than higher rates. The Euro should have popped but instead it flopped after the ECB’s rate hiking decision last Thursday. That says something about the underlying economy and the expectations for interest rates ahead.
This note puts forth data backed arguments that macroeconomic fundamentals in Europe is visibly weak. In sharp contrast, the robust economic fundamentals in the US provide strong tailwinds to the US dollar.
Consequently, the Fed has great monetary manoeuvring space which will impose bearish pressure on the Euro. Having cranked up rates to a peak unseen before, the ECB’s hands are tied with little room for further hikes despite its hawkish tone.
This paper posits a short position in CME Micro EUR/USD Futures expiring in Dec 2023. To seize opportunity from a weakening Euro, a short position with an entry at 1.071 combined with a target at 1.035 and hedged by a stop at 1.1025 will deliver an expected reward-to-risk ratio of 1.14x.
MONETARY POLICY TRANSMISSION TAKES TIME
Over the last year, the ECB has increased interest rates, an unprecedented ten times to combat surging inflation. That is a full 450 basis points.
Yet inflation remains sticky and persistent. Why? One obvious reason is monetary policy transmission.
Monetary policy transmission is the process through which a Central Bank’s monetary decisions impact the economy and the price levels.
The mechanism is characterised by long, variable, and indefinite time lags. As a result, it is difficult to predict the precise timing of monetary policy actions on economy and inflation.
DATAPOINTS SIGNAL WEAKENING ECONOMY
Selected data from the minutes of the Monetary Policy Meeting of ECB Governing Council held in July points to growing weakness in Europe.
1. Yield Curve Inversion Deepening: Together with negative euro area data, the inversion has reignited recession concerns. For now, the Euro area’s equity & credit markets remain resilient, hoping for a soft landing.
2. Sharp Contraction in Euro Area: Euro Area Composite PMI has been declining since April 2023 and in July it has fallen below 50. The dynamics are consistent with a weak GDP performance for the second and third quarters of the year. Housing and business investments are estimated to have declined.
3. Shrinking Demand for Loans: The latest bank lending survey signals further tightening of credit standards and sharp drop in loan demand in Q2 across businesses and households.
The reported demand for loans among corporations had fallen to an all-time low since the start of the survey in 2003 and, for the first time, was lower than at the height of the global financial crisis.
4. Growth could stall due to over correction: Growth could slow far more sharply if effects of monetary policy were more forceful than expected, or if the world economy weakens dampening demand for euro area exports.
AFTER UNPRECEDENTED RATE HIKES, WHAT’S NEXT?
As evident from weakening signals cited above, the ECBs hands are tied. ECB President Lagarde has little option other than maintaining a hawkish tone to manage expectations.
When the ECB regroups again in December, the likelihood of rate hike is thin.
Hawkish pause? Maybe.
As Katie Martin writes in her weekly opinion piece for the Financial Times, “few truly believe the central bank really would raise rates further, especially while the region’s economy feels the strain from the tighter policy enacted so far and from the impact of weaker Chinese demand on German manufacturing.”
ECB’s euro area growth forecasts are on the decline. The central bank expects 0.7% growth for this year (down from 0.9% as previously estimated). For 2024, the ECB now forecasts 1% growth (compared to 1.5% growth projected previously).
Forecasting the future is hard. It is evident from a survey of economists (see chart below) conducted by Bloomberg earlier this month. The market expectations are for rates to stay flat at 4% for now with rate reductions from Q2 next year. When these expectations become consensus, Euro weakening will accelerate.
DOLLAR CONTINUED STRENGTH AGAINST THE EURO
The Euro has shed more than 5% against the greenback since mid-July. Shaky fundamentals and an elevated risk of recession have raised questions on ECB’s ability to continue hiking.
Contrast this against the conditions in the US. The US economy has been marvellously resilient and set to have one of its best years yet. This backdrop emboldens the US Fed to take on an aggressive monetary posture.
TRADE SET UP
Interest rates at record elevated levels combined with weakening economy and feeble prospects, collectively pushes recession risks higher in the eurozone. This will corner the ECB into a pause or even cause it to hint at rate cuts during the December meeting. As a result, the Euro will be pressured lower against the US dollar.
To ride on the opportunities from a weakening Euro, this paper posits a hypothetical short position in CME Micro EUR/USD Futures expiring in Dec 2023 (M6EZ2023) with an entry at 1.071 combined with a target at 1.035 and hedged by a stop at 1.1025, delivering an expected reward-to-risk ratio of 1.14x.
Each lot of CME Micro Euro Futures contract provides exposure to 12,500 Euros. It is quoted in USD per Euro increment. Each pip i.e., 0.0001 per Euro delivers a P&L of USD 1.25.
• Entry: 1.071
• Target: 1.035
• Stop: 1.1025
• Profit at Target (hypothetical): USD 450 ( = 0.036; 360 pips; 360 x 1.25 = 450)
• Loss at Stop (hypothetical): USD 393.75 ( = -0.0315; -315 pips; -315 x 1.25 = -393.75)
• Reward-to-Risk (hypothetical): 1.14x
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
