Selling EURUSD at 1.0795

I have nothing new to add to my commentary on Navarro and the US dollar's strength from yesterday evening, but I'm putting my money where my mouth is: Sold EURUSD at 1.0795. This is not a near-term trade as I can see the pair going up to 1.0875 or even higher during the next couple of sessions (depending on Fed today & any Trump comments we might get), but in the medium- to long-term I believe the EUR short story will play out well. Read yesterday's post for details.

EURUSD short 01/02/2017Open positions as of 01/02/2017 9:38am CET:
EURTRY short from 4.0524, unrealized return: -0.56%
EURUSD short from 1.0795, unrealized return: flat

Realized YTD return: +0.7% from 2 trades
Total YTD return: +0.14% from 4 trades

Ignore Navarro comments, EUR short story intact

Trading started out quiet enough today, but after the Financial Times reported on Donald Trump trade adviser Peter Navarro's comments on a "grossly undervalued" euro today, EURUSD quickly shot up from 1.07 to 1.0813. The pair is currently trading at 1.0799.

Let's be reasonable for a moment though: The inflation outlook for the euro zone does not support any immediate EUR strength ("base effects"), Mario Draghi's ECB is still broadly dovish, and the year 2017 brings plenty of political risks for the currency bloc with tricky elections in the Netherlands, France and Germany. On the other side of the Atlantic, the Federal Reserve is prepping for as much as three interest rate hikes that should, in theory at least, support the US dollar. In fact, if Trump's economic stimulus works out well, the Fed might even be inclined to hike rates faster or more often. Let's not forget that central banks are independent, either! Trump and his advisers have no real business telling anybody that their currencies should be revalued higher or lower, and if they do, the recipients of that message have absolutely no obligation to obey mighty Trump's orders (even if they come in form of a Tweet, which to my surprise has worked pretty well for the president so far).

What should a trader make of this mess? We must surely brace ourselves for an increase in two-sided volatility during the next few months to come. Any comment from Trump, Yellen and Draghi will violently and without warning push both EUR and USD pairs in either direction. The same goes for news about populist parties in Europe gaining support ahead of this year's elections. JPY pairs will be affected too, because the Japanese yen is still a typical currency for risk-on and risk-off trades.

Looking just at EURUSD, I believe the EUR has no real supportive story going for it for some time to come. Comments from Trump's adviser team won't change that. The euro zone has lots of homework to do, and a possible trade war with the U.S. won't help, either.

Resorting to technical analysis, it is true that the charts look slightly more supportive after today. In the daily chart above the pair managed to break out of its downtrend, which started in November 2016, and in the monthly chart it even jumped back over the long-term upwards trendline support going back to 2002 (second chart above). In theory, a monthly close above the trendline would signal that the previous break lower was indeed a false break, especially since EURUSD failed to permanently trade below the March 2015 low at 1.0458 (red dashed line).

Everything else is still telling me that the EUR short / USD long story is intact, however. As mentioned above, I don't attach a lot of value to Mr Navarro's comments anyway. It's more significant to me that EURUSD further decoupled from interest-rate differentials today (I think it will revert back soon) and that speculative EUR shorts ("smart money") have declined yet another week. That means market positioning is less extreme, thus permitting another extended move lower.

Open positions as of 31/01/2017 9:17pm CET:
EURTRY short from 4.0524, unrealized return: -0.26%

Realized YTD return: +0.7% from 2 trades
Total YTD return: +0.44% from 3 trades

The dollar will be stronger going forward

My frequent readers know by now that I've been very vocal about US dollar strength throughout this year. It is true that there have been many a times during the past 12 months when the dollar depreciated against the euro and, in particular, against the Japanese yen. That was usually the case when the Federal Reserve kept the market guessing about its future policy moves, including the timing of its first interest rate hike, or when the European Central Bank could not persuade the market of its capability to sustainably increase inflation through its monetary policies, such as negative interest rates and extensive quantitative easing programmes. However, no matter how tenacious the dollar's sideways range has been (just look at EURUSD, which had been stagnating since April 2015), I've always stuck with my conviction that the US dollar would ultimately emerge from this inconvenient bout of range trading as the stronger currency in comparison to the rest of the G10 currency basket.

The main reason being that the US economy has been able to put its economic recession behind itself earlier than European economies managed to do. This time gap of perhaps one to two years was a strong indicator of increasingly divergent fiscal and monetary policies in the US and throughout the euro zone that would help strengthen the US dollar and, on the other hand, devalue the euro. Although this did indeed happen to some degree up until March 2015 when the EURUSD exchange rate came close to reaching $1.05 but instead came to a halt at the intersection of two long-term trend lines and entered the aforementioned sideways market. I must admit that I greatly underestimated the amount of time it would take for the US dollar to resume its appreciation, and that it would be the election of Donald Trump as the next President of the United States that would trigger the dollar's renewed vigor is still somewhat beyond me.

Anyway, the time has finally come that we're seeing a strong trend in EURUSD again. The only thing that worries me at this time is the pace at which it unfolded. Within merely 10 trading days we went from the election night high of $1.13 to today's low of $1.0568 -- that's almost an eight big figure move without noteworthy backlash! The daily RSI currently reads 22 and other oscillators confirm that the pair is oversold. While I appreciate the fact that such moves often extend even beyond these levels, I must also acknowledge that the previously favourable risk-return profile of the EURUSD short trade has worsened significantly, which is exactly why I closed my USD long trades yesterday. Traders thinking about selling the euro versus the US dollar should think thoroughly before doing so. Personally, I expect a bit of profit taking to begin soon, but I will stand ready to buy the US dollar again once the extreme momentum has abated. The US dollar still has the majority of arguments on its side, and that is not going to change unless the ECB and, more importantly, the Fed will disappoint in December. Next month will be at least as interesting (or should I say, challenging?) as this month turned out to be.

Prepare for pivotal week in FX

As I wrote in yesterday's FX newsletter, traders should prepare for a pivotal week in the foreign exchange market with both the BoJ and the Fed holding important policy meetings.

Judging by the major banks' research reports, most analysts expect the BoJ to attempt to steepen the JGB yield curve, but the effect that would have on the JPY remains open to interpretation. It will perhaps be more crucial that the BoJ can convince the market that it is not running out of options to step up its easing measures if required, but that will be a tough task to achieve without support from Japan's Ministry of Finance. While I expect JPY strength to come to an end soon, the Japanese currency remains supported by the unwinding of carry trades and next week's central bank meetings will provide plenty of downside risk for my base scenario. Given this uncertainty, I'm afraid USDJPY might test the 100 level if neither the BoJ nor the Fed can reintroduce JPY weakness and USD strength, respectively. I hold a USDJPY long position with a S/L just below 100 and a short-term target at 105.

Speaking of the Fed, don't expect too much from Yellen & Co.! A rate hike would be a big surprise that would push EURUSD below 1.10 and USDJPY above 105, but the more likely scenario is that the Fed will (once again) not hike and merely introduce a slightly more hawkish tone to its statement instead. Although that should signal perhaps one rate hike by the end of the year, it will not be broadly USD-supportive and thus the risk of temporary EURUSD and USDJPY volatility without a sustainable breakout from recent price channels remains high, i.e. there will be a lot of risk in the market but the likelihood of an adequate compensation for that risk remains relatively low. Risk-averse traders will remain on the sidelines. Those open to more speculative positions will put on EURUSD short, GBPUSD short and USDJPY long trades.

Fed releases March 19-20 FOMC minutes early

Much to its embarrassment the Federal Reserve had to admit on Wednesday that it had released its March 19-20 FOMC minutes to about 100 lobbyists on Tuesday afternoon, one day before the official release date. As of now, it is not known whether there has been any trading based on information from the leaked document. The minutes have now been posted on the Fed's website.

From what I understand, the wording is still rather neutral without any specific hints at the future direction of the Federal Reserve's asset purchases. According to the minutes, few FOMC members think the programme's costs begin to outweigh its benefits and would hence prefer to reduce asset purchases sooner rather than later:

The staff provided presentations covering the efficacy of the Federal Reserve's asset purchases, the effects of the purchases on security market functioning, the ways in which asset purchases might amplify or reduce risks to financial stability, and the fiscal implications of purchases. In their discussion of this topic, meeting participants generally judged the macroeconomic benefits of the current purchase program to outweigh the likely costs and risks, but they agreed that an ongoing assessment of the benefits and costs was necessary. (...) However, a few participants were not convinced of the benefits of asset purchases, stating that the effects on financial markets appeared to be short lived or that they saw little evidence of a significant macroeconomic effect. (...) In light of their discussion of the benefits and costs of asset purchases, participants discussed their views on the appropriate course for the current asset purchase program. A few participants noted that they already viewed the costs as likely outweighing the benefits and so would like to bring the program to a close relatively soon. A few others saw the risks as increasing fairly quickly with the size of the Federal Reserve's balance sheet and judged that the pace of purchases would likely need to be reduced before long. Many participants, including some of those who were focused on the increasing risks, expressed the view that continued solid improvement in the outlook for the labor market could prompt the Committee to slow the pace of purchases beginning at some point over the next several meetings, while a few participants suggested that economic conditions would likely justify continuing the program at its current pace at least until late in the year.

It is always difficult to interpret the wording of central bank releases, which mostly try to be as neutral as possible in order to avoid introducing excess volatility, but at least there seems to be consensus among the majority of FOMC members that the Fed's quantitative easing programme should be reconsidered over the course of this year. Depending on the further development of macroeconomic indicators, such as an improvement in the next US payrolls data, it is quite possible that the asset purchases will slowly be reduced within the next two quarters. For the time being, currency traders need not fear a sudden end of QE, but in the medium term the Federal Reserve may begin to change course and thereby put pressure on EUR/USD while supporting the upward momentum of USD/JPY.