Currency traders were caught out in September following confirmation of the specifics of the European Central Bank’s new Outright Market Transactions (OMT) programme.
Having cut back on long positions following the announcement, it soon became necessary for many to reposition after the strength of the euro persisted longer than anticipated.
In the run up to ECB president Mario Draghi’s speech, traders didn’t have to go far to find leaked reports of what was to come and those who kept faith in the consequences of his actions were not disappointed.
However, it is easy to see why there was initially some scepticism over Mr Draghi’s silver bullet, given that his early attempt to talk up the market fell short when he failed to provide sufficient additional detail to keep traders happy.
David Kerns, currency expert at Moneycorp, says Mr Draghi’s plans outlined in July left the markets with many questions. He says: “Since it was first made, Mario Draghi’s statement of intent, ‘whatever it takes’, changed the sentiment of traders towards the euro significantly. “In no way was it a complete U-turn of opinion, but the euro has gained a lot of ground against the US dollar since its decline to levels last seen back in 2010.”
A further loosening of the ECB’s monetary policy will be necessary to ease the pain for economies
What followed in September was much more comprehensive, however with the OMT programme lifting the euro considerably.
Angus Campbell, head of market analysis for London Capital Group, says that, during the speech, it wasn’t initially clear which way markets were receiving the news. He explains: “In the first instance, straight after the initial interest rate decision, it seemed to be a case of ‘buy the rumour, sell the fact’ as those risk assets were sold off again, but as Draghi continued to speak, revealing his plans in more detail, the buyers returned and in force.
“A great deal of what he eventually announced had been leaked to the market, such as three-year treasuries being the target and unlimited purchases. Shorts were squeezed out and the strength that followed took quite a few of our clients by surprise.”
Kathleen Brooks, research director at Forex.com, says she also witnessed traders trimming their long euro positions immediately after the announcement.
“The subsequent extension of the rally in the euro means that some people are suffering because they were caught wrong-footed by the announcement from the ECB,” she says.
“They didn’t think the market would buy the OMT programme, but they did. We saw very interesting price action post the ECB meeting; investors bought the rumour and the fact. Those who were the wrong side of the euro trade were left scrambling to get back into the rally.”
The behaviour of institutional traders in particular was interesting. IMM positioning data gives a sense that institutional traders are likely to have been better positioned when the market started to rally following Mr Draghi’s speech.
Ms Brooks continues: “This data has showed two consecutive weeks of investors cutting their short euro positions both before and after the ECB announcement.”
However, economists have kept champagne corks wedged firmly in their bottles. After all, Mr Draghi’s OMT plan has only bought the currency bloc time and it certainly isn’t a cure for the many problems that are still to come.
Ken Dickson, investment director for foreign exchange at Standard Life, says the plan has succeeded in reducing the tail risk of an immediate euro break-up scenario, but there is a long way to go before a resolution will be found.
He says: “For much of 2012, the correlation between the euro and risk was strong, but we expect that this correlation will unravel in the quarters ahead. The growth outlook in Europe is still set to deteriorate and therefore debt sustainability issues remain.
“A further loosening of the ECB’s monetary policy will be necessary to ease the pain for economies that will be subject to years of transition to more sustainable fiscal and economic trends.”
Mr Dickson’s view is echoed in many recent macro investment reports. Among these is that of John Redwood, investment committee chairman at Evercore Pan Asset, who says the issue now is whether Spain plays the game.
“Temporarily buoyed up by lower bond yields, the Spanish government is hoping the hint of intervention will be enough to let them carry on borrowing at sensible rates,” says Mr Redwood.
“If not, they have to take the difficult step of putting themselves into a special programme, which their prime minister is reluctant to do.”
Traders will be looking at several key metrics over the coming weeks which are likely to dictate where the next spate of activity will stem from.
And, as the eurozone crisis has a vast number of political and monetary authorities giving very different resolutions to the crisis, traders have to be aware that the number of stakeholders who can affect market perceptions is large.
Chris Eagle, head of foreign exchange at Marex Spectron, explains that anything from domestic court actions to national elections can augment the noise.
“Global data releases have an effect. For example, weaker China economic data highlights falling demand for European luxury goods which affects trade within the eurozone,” he says.
“Unsurprisingly, the outlook for the euro’s value on the foreign exchange markets remains difficult to predict, although it is clear that break-up of the euro would be a momentous event.”
A momentous event may be required, but some believe it is not beyond the realms of possibility. In the meantime, however, the beginning of the fourth quarter is likely to be dominated by news coming from outside the Continent.
Currency markets are unlikely to be moved as much by the actions of eurozone countries, but more by the drama playing out over the Atlantic in the United States.
Forex.com’s Ms Brooks says the run-in to the US election is now taking central stage alongside the weak labour market there and up-coming fiscal cliff which could soon dominate.
“This could be a genuine sea change, which may be euro-positive for the medium term,” she says. “We have seen some traders scale back their bearish euro positions as the focus shifts to the Federal Reserve and the US.”
Fed’s bid to boost economy
US DOLLAR In the wake of the Federal Reserve’s confirmation of a third round of quantitative easing, Jennifer Lowe charts the behaviour of the US dollar.
Both sterling and the euro have benefited from a weakening dollar in recent weeks, as Moody’s raised fears among traders of a possible downgrade in the United States’ credit rating.
It started in the first week of September, when volatility in the currency markets increased, as the US Federal Reserve embarked on a two-day meeting at Jackson Hole to discuss the possibility of further quantitative easing.
By September 7, in anticipation on the meeting, the US dollar fell 0.94 per cent to 80.28 against major currencies.
The currency has, however, been experiencing extreme volatility and keeping traders on their toes. During May and June the dollar hit a four-week low against both the euro and the pound, recovering only after the Fed announced the extension of the Operation Twist programme.
Andy Scott, premier account manager at HiFX, explains: “Investors appeared to be disappointed the Fed didn’t vote for more aggressive action and the US dollar duly strengthened.”
However, all that changed when it was confirmed in mid-September that the Federal Reserve would purchase US $40 billion of mortgage-backed securities per month until they see a sustainable improvement in economic conditions.
This came in addition to the Fed’s earlier commitment to Operation Twist until the end of the year, totalling US $85 billion of long-term asset purchases every month.
Craig Erlam, analyst for Alpari UK, says: “The idea behind this is to improve confidence in the economy in the hope that, as consumers feel more secure about the outlook, it will encourage them to spend more, thus creating more jobs.
“This will be accompanied by lower long-term rates that should encourage people to make house purchases, driving up house prices and making people feel better off, further encouraging them to hit the shops.”
However, Mr Erlam warns that the Fed may want to rethink the policy questioning whether the central bank has learnt anything from the housing bubble that caused the recession in 2008.
He says: “They are trying to create a housing bubble to clear up the mess from the bursting of the previous one. They will have to be very careful not to let this get out of hand again.
“The Chinese are not as thrilled about the Fed’s decision to ease. They are concerned that it will spur further investment into the Chinese economy and boost inflation, as it has previously. It also previously resulted in rising house prices in China, something the government have worked hard to resist.”
