The euro devaluation process has started
Posted on 06. déc, 2011 by Riskelia in Weekly Focus | Commentaires fermés
It is often said that the EURUSD is a « risk on » asset. When looking for assets that are the most explanatory of EUR/USD returns, we find in decreasing order the World Inflation Bonds, the Crude Oil WTI and the spread Euribor vs. Eurodollar (figure 1).
The first two factors represent monetary effects characterizing the well-established inverse relationship between dollar and inflation. This relationship is due to many converging factors, including the search of reserve diversification from commodity producers, the transformation of commodities as anti-dollar investment asset, and the role of the dollar as a funding currency. This currency effect has also played with other cyclical assets, such as the S&P 500, as illustrated in figure 2. This relationship has been quite robust with a correlation between the single parity and risky assets around 40%.
The last factor of dependency represents the cost of carry associated to a EUR/USD position (EUR short-term rate minus USD short term rate). Last week’s joint central banks’ intervention to provide dollar liquidity to the financial sector was therefore favorable to the EUR. Conversely, the next ECB meeting on Thursday, probably resulting in a further cut of the refi rate, will likely push the EUR/USD downward.
These short-term dependencies and the implied short-term swings along with the risk on/risk off pendulum should not mask the reality of the long-term broad based euro depreciation. As showed in figure 3, the EUR/USD bearish trend is solidly established. For sure, the position is crowded as proved by the CFTC report of Non Commercial net positioning. Besides, a short-term EUR/USD rally is possible in the perspective of the umpteenth euro summit supposed to bail out the euro once again. However, figures 4 and 5 show that the cyclical assets have started to outperform the single currency in the long run. Whereas European investors used to suffer from the EUR over performance up to September, the current EUR/USD negative trend is supporting euro investors’ positions on USD denominated cyclical assets. Gold, oil, equities and worldwide inflation bonds are all displaying a momentum of appreciation against the single currency.
Figure 1: Explanatory factors of EUR/USD returns (apart from other currencies)
Figure 2: 500 days rolling correlation of EURUSD against various financial assets
Figure 3: Riskelia’s recommendation is clearly on the downside
Figure 4: Nasdaq and Brent vs. EUR outperform
Figure 5: Riskelia’s trend indicators are much more stable on cyclical assets vs. EUR
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