By Marc Chandler
1. As the world took a step away from the proverbial abyss with the firming of the US economy and the ECB’s massive liquidity injections in Q1 the dollar suffered. The re-establishment of positions that were liquidated in Q4 and unwinding of part of the large long dollar positions amassed were key drivers. Those moves appear to have run their course. The dollar will likely trade better in Q2 than in Q1. The main exception is the dollar-yen, where the yen is likely to recoup some of its outsized losses from Q1.
2. As the euro rose in Q1, implied volatility collapsed, falling to the lowest levels since Lehman’s demise. Even if one does not trade options or follow them closely, it is important to appreciate that the compression of volatility is often like a coiling spring, and tends to proceed large spot moves. If vol fell as the euro rose, vol is likely to increase as the euro falls and this is what has begun happening over the past couple of sessions. Also judging from the pricing of puts and calls (as in the three month risk-reversal), the discount for euro calls in late March to its lowest level since Q1 11. However, this is reversing as participants buy puts (vol is rising so premium is being paid) and this also reflects the ascendancy of euro bears.
3. It is not just the case of the shift in views about the prospects QE3. We have argued the economic conditions in Europe have deteriorated. We are concerned that there is still no closure in Greece despite the PSI. Italian and Spanish bond yields are rising not falling as are CDS prices.
4. In addition, there are a number of political events that pose risk to the euro over the next several weeks, Greece and France hold national elections. It is not clear that the current coalition of Pasok and New Democracy are going to secure a majority, warning of possible concessions to less pro-European smaller parties. In France, although the first round appears to have tightened, Hollande still enjoys a large lead in all-important second round. Italy will hold municipal elections next month and it will be seen as a referendum on Monti, whose public support has waned since push to weaken the infamous Article 18, which ossified the labor market. Germany holds two state elections, which should not be much of a market factor. Further erosion of support for the FDP party increases the likelihood that next year’s national contest produces another Grand Coalition between the CDU/CSU and the SPD. Although Irish referendum’s have had market impact, this time is likely to be different. The polls show a comfortable majority favor approving the fiscal compact. In addition, unlike other referendums, the fiscal compact is to be decided by a qualified majority, which means the unlikely veto would not derail the compact, but simply cut Ireland off from further aid, should it be necessary. Lastly, we note that the Dutch government nearly collapsed last week and while it survived it has yet to resolve the underlying budget problem.
5. The technical support for the euro has weakened considerably. The break down has followed the repeatedly unsuccessful attempts to go push through $1.34. The measuring objective of what may be a double top is near $1.3100, but the bottom end of the euro’s trading range is closer to $1.2975-$1.3000. The 5-day moving average is poised to fall below the 20-day moving average indicating that short-term trend followers and momentum players are likely to be more inclined to sell rather than buy the euro. Although this signal has whipsawed participants in recent weeks, it does have a good record of catching big moves. The lower end of the euro’s trading range is also seen by some technicians as the neckline of a larger head and shoulder’s topping pattern, which if broken projects toward $1.25. Based on current spot and volatility levels, indicative pricing suggests almost a 50% chance of testing the mid-Jan low near $1.26 here in Q2.
6. We have often found that the euro is sensitive to changes in the interest rate differential between the US and Germany. In the past, a flare up in the European debt crisis has led to safe haven flows into Germany, pushing down its interest rates and widening the differential in the US favor. While we have highlighted the risk of the re-emergence of euro zone tensions, growth differentials also seem to be fueling a widening of the interest rate spreads. The 10 year spread is at its widest level since mid-2010. The 2-year differential is near its best levels since then, having risen from about 2 bp after a seemingly dovish Bernanke talk near the Ides of March to 17 bp earlier today.
7. The correlation between the euro and the S&P 500 (60-day period on percent change) has fallen nearly in half from a record high in early Dec of 0.85 to 0.43 in late March. The correlation has begun stabilizing as has the 30-day correlation. Short-term market participants should be prepared for a tighter correlation in Q2.