For the past few months, Goldman Sachs has had a problematic trade on its hands.
On October 22, 2012, the bank's currency strategists recommended clients go long the euro against the Canadian dollar. The trade was initiated at a level of 1.296 with a target of 1.37. (At the time, Goldman saw more upside to the euro in Canadian than in U.S. dollar terms, owing to a projected shift in Bank of Canada monetary policy).
The trade has gone nowhere. It reached its highest point on December 28 – but by then had only risen to around 1.3170. After that, it tanked into the new year and has languished in recent days.
That is to say, the trade languished up until yesterday, when ECB President Mario Draghi revealed that the central bank's latest decision not to cut interest rates was unanimous on the Governing Council.
Since then, the euro has staged a sizable rally.
Today, Goldman Sachs FX strategist Robin Brooks says in a note to clients that it should go much higher. However, Brooks' reasoning still has more to do with what Draghi said in July – that the ECB would "do whatever it takes to save the euro" – than what he said yesterday.
Since the introduction of the ECB's OMT bond market intervention later this summer, government borrowing costs have dropped precipitously in the periphery. Nowhere is this more apparent than in Italy, where the spread between Italian 10-year sovereign bonds and German bunds fell below 250 basis points today for the first time since before the euro crisis exploded.
However, recently the euro crisis conversation has turned to fundamental economic growth and eurozone member states' inability to meet economic targets. Today, t he rate of contraction in Spanish industrial production unexpectedly accelerated to a staggering 7.2 percent, well below the 3.1 percent decline in the previous month and economists' expectations of a 1.5 percent contraction.
Hence, a new debate: what's really driving the euro?
Brooks thinks it's still the former factor, OMT's effect on peripheral bond markets, that still has the most pull. The Goldman strategist calls it the "fiscal risk premium" – measured as the GDP-weighted spread between euro periphery bond yields and yields on German bunds.
This fiscal risk premium, Brooks says, trumps the 2-year swap rate differential (a proxy for economic growth) in explaining euro moves:
Over the last three months, the fiscal risk premium has explained about 16% of daily variation in EUR/$, compared to 9% for the 2-year swap rate differential. The fiscal risk thus clearly dominates the rate differential, something that has been the case since the middle of 2011.
However, something curious has happened recently, Brooks notes (emphasis added):
Now, the importance of both factors in explaining EUR/$ variation has fallen in recent months. In the middle of 2012 the fiscal risk premium explained up to around 50% of daily variation in EUR/$, with the 2-year swap rate differential accounting for 25%.
Meanwhile, the oil price has become a more important driver of EUR/$, accounting for 14% of daily variation, even as variations in global risk appetite essentially play no role for EUR/$... A good chunk of the recent drop in EUR/$ therefore fails to map into any of the fundamentals we examine here, something we examine next.
This leads Brooks to conclude that the drop hasn't been driven by fundamentals, which means the euro now has some upside to stake out in order to catch up to the price appreciation in peripheral sovereign bonds over the last several months.
In other words, it's mostly a mean-reversion trade.
And since Goldman thinks those peripheral bonds will continue to rally, Brooks sees even more additional upside to the euro, writing, " Putting a number of things together, we think upside is currently around 6 big figures, which is what lies behind our ongoing tactical recommendation to be long EUR/CAD with a target of 1.37."
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