By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman
1. The odds of a country exiting the euro zone this year has fallen from above 40% on the eve of the Greek election to about 27% today, according to Intrade.com. Previously the euro appeared to track the “break up” fear. However, it has found little succor in the reduced exit speculation.
2. We often find that the euro also tends to move in the same direction as the US-German 2-year interest rate differential. The premium the US offers over Germany is hovering around 28 bp, its best level since late 2007.
3. In the options market, there continues to be a premium for euro puts over euro calls equidistant from the money (3-month 25 delta), but that premium has been sharply reduced. As recently as mid-May, participants were paying as much as 3.5% more for puts than calls. Now, they are paying about 1.5%, which is the least since late March. It appears that what is happening is that the euro bears are buying some cheap protection for their short euro position by buying calls. This insurance is relatively cheap because volatility is still relatively low in the euro. Three-month implied volatility is now near 11%. The 50-day moving average is near 11.6%. Three-month implied vol was just above 10% at the start of the month.
4. Looking at the IMM Commitment of Traders on a net basis misses as is the traditional way misses what is really happening. Gross shorts have been reduced by about 30% to 178.4k contracts as of July 3 from June’s record. However, gross longs were cut more than 40% to 32k contracts. A point we have made before is worth reiterating, the foreign exchange market is overwhelming a cash market. The futures market is relatively small part of the daily turnover. Large futures positions in and of themselves may not be a good guide of extreme readings. It may be best used for insight into the momentum and trend following market segment.
5. The recent decline in the euro has brought it below the OECD’s measure of PPP. The last time the euro was below PPP was back in April-June 2010. Before that one needs to go back to 2003 to find the euro under-valued by this metric. The OECD estimates the euro is about 2.3% below “fair value”. This is a minor overshoot. Back in 2008, when the euro was posting its record high, it was around 23% over-valued. In the early 2000′s, the euro was about 35% under-valued. Leaving aside tactical opportunities, the euro’s under-shoot is not sufficient then for strategic mean reversion strategies.
6. We look for the euro to continue to trend lower. We expect psychological support near $1.20 to be tested in the coming sessions and then a push toward the June 2010 low just below $1.19. Since the five day moving average broke below the 20-day around July 4, the 5-day moving average has contained upticks. It comes in near $1.2255 now.