Market Commentary │ March 27, 2014

Weekly Roundup
Tom Fitzpatrick 1-212-723-1344 thomas.fitzpatrick@citi.com Shyam Devani 44-207-986-3453 shyam.devani@citi.com Dan Tobon 1-212-723-1576 daniel.tobon@citi.com

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Chart of the Week – Why does the EURO refuse to go lower?
– – –

Contrary to most consensus views (Including ours) EURUSD has failed to move lower in 2014. Why? We think there are some valid arguments in this respect, which fit very well with the historic dynamic seen in 1997-1998. If so then it still remains only a matter of time before market dynamics will reach a point where EURUSD once again makes a strong move to the downside.

Market Commentary │ March 27, 2014

Chart of the Week – Why does the EURO refuse to go lower?
– – –

Contrary to most consensus views (Including ours) EURUSD has failed to move lower in 2014. Why? We think there are some valid arguments in this respect, which fit very well with the historic dynamic seen in 1997-1998. If so then it still remains only a matter of time before market dynamics will reach a point where EURUSD once again makes a strong move to the downside.

EURUSD long term chart:

91 months uptrend 1992-1995: ERM Crisis

93 months uptrend

2009-2012: European Bond market crisis

16.5% rally within the downtrend into October 1998 At this point peripheral bond market yields (Italy/Spain) had almost converged to Germany across the yield curve as had FX rates.

16.0% rally so far off July 2012 low

?

Source: Aspen graphics/Bloomberg March 26, 2014.

  

The long term EURUSD chart shows the similarities with that seen in the last USD cycle throughout the 1990’s Both rallies were similar in length as were the background economic dynamics (housing boom and subsequent bust in the US in the early 1990’s and again in 2006-2007) The highs came in 1992 and 2008 and the major developments that followed three years after each of those highs was a currency crisis in Europe – ERM crisis in 1995 and the European Sovereign debt markets crisis in 2011. Within the bear market for EURUSD that came after 1995 we can see there was a decent correction up from August 1997 into October 1998 which saw EURUSD bounce 16.5% Since the low posted at 1.2043 in July 2012, EURUSD has bounced 16% so far. As a consequence we believe an important peak has either been put in place or is coming relatively soon which would mark a turning point that is likely to send EURUSD back to the 200 month moving average at 1.2134 A monthly close below that 200 month moving average (which has limited the three major falls in EURUSD over the past 10 years) would then open the way for much lower levels still over time (Possibly to parity or below over the next 2-3 years)
Weekly Roundup March 27, 2014

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Market Commentary – for Institutional Client Use Only. Refer to informational disclosures and qualifications at the end of this publication.

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Market Commentary │ March 27, 2014 EURUSD 1995-1998 and 2011-2014 - Not identical but pretty similar

Peaks in October 1998 with a 16.5% rally as convergence trade gets close to endgame. Falls 20 big figures in following 8 months

Peaks in April 2014 with a 16.0% rally as convergence trade gets close to endgame?

Source: Aspen graphics/Bloomberg March 27, 2014.

When we look at that rally in the EUR (As its components ITL,ESP,FRF etc.) into late 1998 we saw two strong convergence trades taking place

FX rates: Following the devaluations into the peaks in early 1995 peripheral currencies eventually converged in late 1998 to their “entry fixings” in the new single currency.

Deutsche Mark Italian Lira- During ERM crisis and into creation of the EURO

Source: Aspen graphics/Bloomberg March 27, 2014.

Massive devaluation from 1992-1995 of Italian Lire followed by convergence trade into the Euro fixing rate in late 1998. That level still left the ITL about 30% weaker than 1992 and combined with the bond market move was very stimulative. In today’s crisis there has been no scope for an internal FX devaluation in Europe hence the fiscal austerity program, which is much more damaging domestically.

Market Commentary – for Institutional Client Use Only. Refer to informational disclosures and qualifications at the end of this publication.

Weekly Roundup March 27, 2014

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Market Commentary │ March 27, 2014

Bond yields: Having hit 13.8% in March 1998 and a spread to Germany of about 650 basis points, Italian 10 year yields fell to 3.90% by December 1998- converging totally with German rates. The turning point in the EURUSD rally of 16.5% (As its components) had effectively occurred 2 months earlier in October 1998. The week of that peak in EURUSD the spread between 10 year Italy and Germany closed at 54 basis points.(The 2 year spread was about 56 basis points also making the Italian spread to Germany consistent across the curve).Why is this important? This dynamic clearly showed that as far as the market was concerned a single currency pretty much meant a single bond market- hence the ultimate convergence to ZERO right across the curve 3 months later just before the official launch of the EURO.

For the purposes of this piece we are focusing on Italy (albeit we could just as easily use Spain in this example) Italy Germany 10 year yield spread/Italy 10 year yields/EURUSD

Between July 1997 into October/December 1998 the market increasingly believed that we were heading for one currency and one bond market in Europe. Peripheral yields fell in Europe, spreads converged and exchange rates headed towards their fixing rates in the Euro. During this period we were also seeing money come back out of emerging market countries (Asia crisis and Russia default) after the prior search for yield making European peripheral currencies and yields look attractive.

Source: Aspen graphics/Bloomberg March 27, 2014.

Market Commentary – for Institutional Client Use Only. Refer to informational disclosures and qualifications at the end of this publication.

Weekly Roundup March 27, 2014

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Market Commentary │ March 27, 2014

So we had no real value left in the convergence trades and the US curve (Equally weighted 2’s,5’s,10’s spread between Germany and the US) was on average 67 basis points in favour of the US (Compared to 82 today). That meant that once there was no value in playing the convergence trades of FX and yield the US/Europe interest rate differential/economic dynamic came into play in favour of the US and ultimately the USD.

Equally weighted Germany minus US 2’s,5’s and 10’s yield curve

Oct 2013

Oct 1998

June 1999

?

Source: Aspen graphics/Bloomberg March 27, 2014.

 

Between October 1998 and June 1999 we saw the spread move from around 44 basis points in favour of the US to over 220 basis points During that same period
– – – –

US 10 year yields rose from 4.42% to 6.08% US 2 year yields rose from 3.85% to 5.75% The spread between US 2 year yields and Fed funds approached 100 basis points in late June 1999 The Fed began a tightening cycle on 30 June 1999 into May 2000
th

As you will see in our recent fixed income note (Chart of the Week – QE is dead…long live normalization), this overall dynamic is not all that different from how we view US fixed income in the months ahead.

Market Commentary – for Institutional Client Use Only. Refer to informational disclosures and qualifications at the end of this publication.

Weekly Roundup March 27, 2014

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Market Commentary │ March 27, 2014

The problem we see this time is that there is no way (in our view) we would expect the market (peripheral yields) to converge all the way to German yields again, especially in the longer end of the curve. It is obvious with what has happened in recent years (Default in Greece and deposit confiscation in Cyprus) that there is not a single bond market in Europe. While the premium at the short end of the curve (2 year) is now back close to those levels seen in 1998 at 68 basis points (compared to 54 in October 1998) the spread at the longer end (10 year) stands at 177 basis points (compared to 54 basis points in October 1998). This shows that while concerns are alleviated in the near term the overall “issues” are still a concern.

Italy minus Germany 2 year yield spread
1995 peak 2011 peak

October 1998

2014 low so far

Source: Aspen graphics/Bloomberg March 27, 2014.

The peaks seen in 1995 (724 basis points) and 2011 are very similar and we are now very close to the levels of October 1998 (56 basis points) and also the lows off which the major move higher began in 2011(April 2011 lows of 56 basis points)

Italy minus Germany 10 year yield spread
1995 peak 2011 peak

2014 low so far

October 1998

Source: Aspen graphics/Bloomberg March 27, 2014.

 

In 1998 this spread peaked at around 650 basis points compared to around 550 basis points in 2011(Albeit off a much lower level of yields) By October 1998 it had fallen to 61 basis points whereas today it stands at about 176 basis points. The surge higher in 2011 came from levels around 122 basis points. While a move towards that level (About another 50 basis points) may be possible, we doubt we can continue to converge like we did in 1998.

Market Commentary – for Institutional Client Use Only. Refer to informational disclosures and qualifications at the end of this publication.

Weekly Roundup March 27, 2014

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Market Commentary │ March 27, 2014 So at what point in this cycle does the “value proposition” no longer provide support for the EURO. We do not believe that this number is Zero (Spread between Italy and Germany right across the curve) for the reasons above but we do have a subjective view as to when those “alarm bells” should ring.

Right now Italy has a spread of 68 basis points to Germany in 2 year rates and 38 basis points to the US. In the 10 year period those spreads are 175 basis points and 60 basis points respectively. For somebody looking to take advantage of this dynamic you pretty much have 3 scenarios
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Domestic European investors can play the convergence trade between Germany and Italy…but for how much longer as these spreads contract? There is no underlying FX trade here. Foreign investors can play this convergence trade hedged. Now, normally a hedged trade would be a Zero sum game if the hedge went to the maturity date but this is not a normal setup. At present a US investor could get about 84 basis points to invest in 2 year Italian notes. This compares to about 45 basis points in the US (So almost double the yield to take the short term bond risk). In a normal World hedging this would make this a zero sum game and the cost of forward cover (buying and selling EURUSD) would equate to around the difference of 39 basis points per annum. However, the forward points on EURUSD do not reflect the interest rate differential between the US and Italy but are more closely aligned with German rates. As a consequence you RECEIVE about 72 pips when you buy and sell EURUSD spot to 2 years out thereby you RECEIVE about 26 extra basis points per year giving you a yield of about 110 basis points compared to the 45 basis points in the US. Again, there is no underlying FX trade here as it is just an FX swap thereby hedging FX risk. Despite the fact that neither trade above has an actual FX component they both contribute to the convergence trade which is one of the main things we believe has encouraged EUR buying (As we saw in rd 1997-1998). As a consequence the 3 trade is the buying of peripheral bonds unhedged in the belief that you gain from
  

The directional move in the bonds/notes (Italy) The outperformance to both US and Germany by Italian bonds An FX gain

So overall the unhedged investor looks to get paid for all aspects of the risk being taken. When is this not the case? Once Italian yields converge to US yields (If they do) then a USD based investor no longer gets paid to take that bond risk…so why would you? Combine that with the compressed spreads with Germany today being close to those seen in October 1998 (2 year) and the belief that risk “premia” will prevent a narrowing at the 10 year area to Germany like we saw in 1998 and we have to believe the peak in the bond trade/convergence trade and thereby the EURUSD trade is close. In our view, if and when these rates converge/or get very close to converging with US rates it no longer looks like an attractive trade. At that point the spread chart above of the US versus German curves could well come into play just as it did in 1998-1999.

Market Commentary – for Institutional Client Use Only. Refer to informational disclosures and qualifications at the end of this publication.

Weekly Roundup March 27, 2014

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Market Commentary │ March 27, 2014 Italy minus US yields (10’s and 2’s)

Source: Aspen graphics/Bloomberg March 27, 2014.

 

As the Italian-US 10 and 2 year spreads converged from 2009-2010 (red arrows) towards zero and about 25 basis points respectively, EURUSD ignored the move and continued during the same period. That changed in both instances at around 60-80 basis points where EURUSD topped out before falling from above 1.51 to below 1.19 over the following 7 months. EURUSD therefore turned lower before the full (or as close to full as it was going to get) convergence took place. The high so far in this EURUSD move was posted at 1.3967 on 13 March .On that day the 10 year spread stood at 79 basis points and the 2 year spread at 57 basis points. Given where the spreads currently are, this suggests that the move could well have already run its course to the topside in EURUSD but if not that it is very close.
th

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Given that we think US yields can soon head higher again both in the 2 and 10 year periods this would likely only serve to exacerbate the situation by either:
 

Dragging peripheral yields with them or Narrowing those spreads even further

Neither scenario should be good for the Euro.
Market Commentary – for Institutional Client Use Only. Refer to informational disclosures and qualifications at the end of this publication.

Weekly Roundup March 27, 2014

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Market Commentary │ March 27, 2014

We believe, as noted in our Weekly Roundup last week titled “QE is dead…long live normalization” that a platform is forming for a move higher in US yields. Initially we expect this to be led by the “belly” of the curve (5 and 10 year) and ultimately look for the 2 year to “take up the running”. It is at this point that we strongly believe that the trade above (FX and fixed income convergence) will have fully run its course and open up the way for the next material move down in EURUSD that could see us close to parity in the next 2 or 3 years. (As per our recent bulletin titled “The long term USD rally begins”. On top of this there are some important EURO specific dynamics that bear looking at. One is the monetary/inflation dynamics in Europe and how EURUSD has affected that. The other is the argument that Europe is potentially the next Japan (We agree) and therefore the EUR is going to be very strong in a depressed economic/deflationary environment (We disagree).

Brent Oil in EUR terms/ Harmonised EU consumer prices/ ECB rates. No deflation Mario? Really?

Brent in EUR terms

Harmonised EU inflation

ECB rates

Source: Aspen graphics/Bloomberg March 27, 2014.

  

As we can see the sharp rise in CPI in 2007-2008 was led by a sharp Oil price rise and culminated in a misguided raising of rates by the ECB Oil then collapsed in 2008 leading to a collapse in inflation and economic activity leading to a sharp ease by the ECB Then, following the 2010-2011 surge in Oil prices followed by a surge in inflation the ECB made exactly the same mistake and tightened again. This is where it is different this time. Despite the easing of ECB rates from
Weekly Roundup March 27, 2014

Market Commentary – for Institutional Client Use Only. Refer to informational disclosures and qualifications at the end of this publication.

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Market Commentary │ March 27, 2014 1.5% in 2011 to the present 0.25% level and the absence of any drop in the Oil price inflation has collapsed from 3% to 0.7% and sits at the lowest levels since late 2009

This suggests that something much more structural is at work and is totall y at odds with the ECB’s no chance of deflation assertions. If they are not worried they should be.
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There is now little scope for further traditional easing as we sit at 25 basis points already. ECB deposit rates are already at Zero (25 basis points under lending rates) with no discernible effect. So talk of negative nominal deposit rates seems “moot” as an effective rather than psychological tool. Renewed direct asset purchases by the ECB would almost certainly need a number of things to be a credible stimulus
  

Broad based on some GDP weighted formula including Germany Put in place with no austerity requirements Not associated with any preferred creditor status for the ECB

The problem with this is that it in effect would create a de facto single bond market with joint and several liabilities among Euro nations (Bonds would be on ECB’s books) and it is not clear that Germany is yet (If ever) prepared to sanction this.

So where does that leave scope for stimulus? The exchange rate. To us it is no coincidence that all the monetary policy rhetoric we have heard from the ECB officials in recent months has come as the EURO has moved higher. The chart below supports this contention , in our view

Market Commentary – for Institutional Client Use Only. Refer to informational disclosures and qualifications at the end of this publication.

Weekly Roundup March 27, 2014

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Market Commentary │ March 27, 2014 Euro monetary conditions index as at Dec 2013.

Aug 2012

Feb 2008

MCI: Monetary conditions index: This peaked in Aug 2012 (Loosest point of the MCI cycle which started easing in Feb 2008). RIR: Real interest rate: Also eased dramatically since 2008 and was loosest around the same time as the MCI was at its high. It has since marginally contributed to a tighter MCI. REER: Real effective exchange rate: Has moved down totally in tandem with the MCI. In Feb 2008 EURUSD was at 1.6020 and peaked at 1.6040 in July. In July 2012 it was at 1.2043. It hit 1.3967 (16% rise by March 2014 having been at 1.3893 in Dec 2013, the last month with this data. It is clear from the chart above that the overwhelming contribution to tighter monetary conditions has been the exchange rate followed by falling inflation (Causing real interest rates to rise) and that Europe now desperately needs a weaker currency to help stimulate the monetary conditions gain. After Draghi came out with the rhetoric of “we will do what is needed to preserve the Euro and it will be enough” (July 2012) EURUSD unfortunately did exactly the opposite of what was needed and has rallied 16% since that month. Now despite repeated rhetoric (In a misguided attempt to avoid action) designed to stop the Euro moving higher it remains at exactly the same level as it was at in December 2013 when the data above was last made available. (Remember 2008 when EURUSD peaked at 1.6020 and then at 1.6040 3 months later before turning)
Weekly Roundup March 27, 2014

Market Commentary – for Institutional Client Use Only. Refer to informational disclosures and qualifications at the end of this publication.

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Market Commentary │ March 27, 2014

So what can they do? As we noted above…not much . At best the psychological effect of moving from negative real rates to negative nominal rates accompanied by a statement that the strength of the EURO is tightening monetary conditions and increasing the deflationary risks might be sufficient to turn the currency lower.

There is also a sea of opinion that says a recessionary European economy with deflation and a high current account surplus is reminiscent of Japan and would likely send the Euro higher .We agree on the concerns about the outlook but not the conclusion
– – –

Japan was and is one economy with one bond market and a central fiscal system. Europe is a gathering of separate countries with different bond and fiscal systems and no fiscal transfer mechanism. In tough times Japan tends to act together like “Japan Inc.” while Europe gets territorial and Nationalist Japan’s current account surpluses were Japan’s surpluses. Germany is the primary s urplus nation in the Eurozone and it is not likely to be “gifting” those surpluses externally anytime soon . When it comes to the periphery recent surpluses are more to do with falling imports than economic health. Japan has one banking system. Europe cannot even agree on a pan European bank deposit guarantee system. As the backdrop deteriorated in Japan they moved to a QE approach which they have revisited recently but they did not default despite rising debt levels and financed that debt predominately internally. When the backdrop deteriorates in Europe they “take your money” through default and deposit confiscation. (Neither of which policies they rule out going forward). This default without devaluation fails to economically stimulate especially as it is accompanied by austerity measures. This suggests that the Euro goes down as part of the solution (Good weakness and our preferred and likely scenario) or as a renewed part of the problem (Bad weakness, economic and political fragmentation, social discord, haircuts and confiscations which would almost certainly result in the ultimate demise of the Euro). This is neither our preferred or expected scenario but more of a tail risk event.

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Conclusion:    We are no less convinced than we were at the start of the year that EURUSD is going to head much lower over the coming years We anticipated this move would already have begun at this stage yet we sit at almost the exact level where we closed 2013 We believe the “day of reckoning” is not far away and that as detailed above the building blocks are now falling in place. We may have already peaked with the marginal new high posted at 1.3967 this month but either way we are skeptical of any sustainable move over 1.40 materialising and still believe that we may see EURUSD much closer to 1.20 than 1.40 before this year is behind us.

Market Commentary – for Institutional Client Use Only. Refer to informational disclosures and qualifications at the end of this publication.

Weekly Roundup March 27, 2014

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Market Commentary │ March 27, 2014

Portfolio update:
Position, Instrument and date
 Long USDJPY 06 March 2014 

Comment
Turning higher just shy of good supports Daily momentum also turned higher from historically stretched levels Bullish break confirmed as was a bullish outside week on the Nikkei. US yields are also likely to move up which is likely to support USDJPY on the margin

Entry price, stop

Target

Exit date and price

Profit/Loss

% of Capital used

102.74 S/L: 99.75

105+ and then 110

----

----

20%

 Long USDJPY 07 March 2014

103.32 S/L: 101

110

----

----

20%

Total Capital Used
Source: Aspen Graphics / Bloomberg March 27, 2014.

40%

Market Commentary – for Institutional Client Use Only. Refer to informational disclosures and qualifications at the end of this publication.

Weekly Roundup March 27, 2014

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Market Commentary │ March 27, 2014

Short-term conviction views1:
Instrument View / Comment Date Established Target Level today

 Gold 

Bullish weekly reversal and weekly momentum crossing up as we bounce from the lows set in 2013 A decent bounce should be seen to $1,433 17 Feb: Remains above the reverse head and shoulders breakout level at 30.20-24. Uptrend still in place Updated comment 24 Mar: Held the 200 week moving average again and is likely to rally to the double bottom neckline at $112.39

06 Jan 2014

Initial target met ($1,361) Next target: $1,433

$1,292

 USDTWD

27 Jan 2014

30.71 and then 31.54

30.55

 Brent

10 Feb 2014

$112.39

$107.68

 USDJPY

76.4% retrace against the lows and a bullish outside week suggest a rally to the trend highs again Good hold of support levels in the 3.50% area and outside week along with a double bottom points towards a test of the 4.00% area Comment: 17 March: Hammer patterns across the curve indicate higher yields Higher highs and a close above the 200 day moving average indicates a move to the reverse head and shoulders target at 0.95

10 Mar 2014

105.45

102.14

US 30 year yield 

10 Mar 2014

4.00%

3.52%

 AUDUSD

26 Mar 2014

0.95

0.9258

Source: Aspen Graphics / Bloomberg March 27, 2014.

1

Convictions represent the views of the CitiFX Technicals staff and not actual trades.
Weekly Roundup March 27, 2014

Market Commentary – for Institutional Client Use Only. Refer to informational disclosures and qualifications at the end of this publication.

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Market Commentary │ March 27, 2014

Contacts

Global Head of Value Added Services & Products Stephane Knauf Corporate Solutions Group Joakim Lidbark FX Technicals Tom Fitzpatrick FX Strategy Steve Englander New York 1-212-723-3211 steven.englander@citi.com New York 1-212-723-1344 thomas.fitzpatrick@citi.com London 44-20-7986-1585 joakim.lidbark@citi.com London 44-20-7986-9486 stephane.knauf@citi.com

Quantitative Investor Solutions Kristjan Kasikov Value Added Products Nicolas Thomet New York 1-212-723-6014 nicolas.thomet@citi.com London 44-20-7986-3032 kristjan.kasikov@citi.com

Published by: CitiFX Wire 27 March 2014
Contact: CitiFXTechnicals@citi.com https://icg.citi.com/data/documents/S&T_ExternalDiscl_0209.pdf
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Market Commentary – for Institutional Client Use Only. Refer to informational disclosures and qualifications at the end of this publication.

Weekly Roundup March 27, 2014

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Market Commentary │ March 27, 2014

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Weekly Roundup March 27, 2014

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