Trade: EUR/USD in takeoff position

In his book “Soros on Soros”, George Soros talked briefly about the tendency of currencies to move in large waves that span many months or years. If you look at the chart of EUR/USD for the past 30 years you see exactly that. We believe that we are at/near a turning point in one of those waves. Within this trade we see both technical and fundamental factors at play that point towards the same outcome, the euro appreciating against the U.S. dollar for the next year or longer.

The Fundamentals

The thesis is simple, we’re betting that the European Central Bank will be able to fend off inflation better than the Federal Reserve. Since the start of 2021, the euro has fallen over 15% against the dollar, which matches up exactly with the S&P 500. This is less a result of a correlation between the S&P 500 and the euro, but more about investors getting out of equities and flooding to the so-called safety net of the dollar.

The dollar is anything but a safety net. True inflation in the U.S. is close to 20%, and the economy will collapse if rates get anywhere close enough to reduce it. Luckily for the fed they will have an excuse to put a halt to the rate hikes and quantitative tightening when it becomes clearer that the U.S. is in a recession. Last week the Atlanta fed revised its estimate for Q2 GDP growth to 0.9%, which would follow a -1.5% decline in Q1. Averaging those two figures and you have a two quarter period where GDP decline: the definition of a recession. We think GDP growth will be well below the 0.9% prediction, which would offer the fed an excuse to slow down their current tightening cycle.

Rising prices, falling employment & productivity, and a nation with too much debt are the perfect ingredients for a mega inflationary storm. We refrain from using the word hyperinflation yet because that gives the idea of end of the world, but it isn’t outside the realm of possibilities. The fed funds rate will never get above 3% because it spells doom for the economy. We believe that double digit inflation tied with a recessionary economy is the most probabilistic situation going forward, which is the reason for our bearishness on the dollar.

Once the realization of the dollar no longer being a safe haven sets in, all investors will be flooding out and looking desperately to find the next safe haven of a currency. The euro has been depressed for a while, due to investors giving the fed too much credit in its ability to fight inflation as well as the Russian invasion of Ukraine – the euro is down 6% since the invasion. Once it is understood that the dollar is a confidence game built on a house of cards, we expect the euro to largely strengthen against the dollar.

The Technicals

As you can see in the graph below, the EUR/USD pair has been bound in a large range since early 2015. We are currently at the bottom of that range, which can be volatile and is why we urge caution. Picking bottoms is a fools business; this is not what we are doing. In mid-May the euro reacted well to the resistance of $1.035 that dates back to late 2016, which was a positive sign for us before initiating this trade. We have taken a small position at $1.05. A small position because we place a high probability on the dollar making a final push higher against the euro – as is often happens in tops and bottoms. In a case where the euro pushes closer to parity with the dollar, we will enter again to make our position larger.

Daily candle stick chart of EUR/USD

In conclusions, we expect the euro to eventually break the $1.25 level – though this may take some time. As this is written, the euro buys $1.05, and we admit that it is very possible that the pair steer closer to parity in the near future. This is why we are cautious when opening this position. We will slowly add to this position as the weeks go on, because trend reversal in foreign exchange markets often take months to materialize.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s