Euro-Dollar Buttressed by Eurostoxx's "Remarkable" Rally

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The Euro Stoxx 50 (SX5E) index has experienced an 8-day consecutive upward trend. This could be helping to underpin the Euro against the Dollar.

"European equities witnessed a remarkable upside squeeze since the end of November, with SX5E up 8 consecutive days, and outperforming SPX for all 8 days, a feat seen only once before in over 25 years," says Anshul Gupta, an analyst at Barclays.

The upswing in European stocks has resulted in an exceptionally high information ratio for the SX5E, signifying robust risk-adjusted returns.

The rally has been broad-based, encompassing most European sectors and even positively impacting the Euro to Dollar (EUR/USD) exchange rate.

"This monotonic drift higher led to an all-time high information ratio for SX5E, and was quite broad-based, pushing up most EU sectors and even EURUSD," says Gupta.

Barclays attributes this surge in Eurozone stocks to several key factors:

Significantly Bearish Positioning: The market held a pessimistic view of European equities leading into this period. This negative sentiment, stemming from concerns over tariffs, growth prospects, and political instability, likely created an environment where much of the potential downside risk was already factored into the market.

Image courtesy of Barclays.

Technical-Driven Squeeze: The 8-day winning streak for SX5E, coupled with its outperformance of the S&P 500 over the same period, is a statistically rare occurrence, observed only once before in over 25 years

This suggests a technical-driven squeeze, amplified by the unwinding of short positions, particularly by Commodity Trading Advisors (CTAs)

Potential for ECB Rate Cuts: Barclays highlights the increasingly dovish stance of the European Central Bank (ECB) as a supportive factor for European equities.

The likelihood of rate cuts, amidst political uncertainty and lacklustre growth, provides a buffer against short-term downside risks.

For the Euro-Dollar rate, rate cuts are typically held to be a headwind as it implies lower Eurozone bond yields. But the filip to European stocks could limit any downside.

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Favourable Response to News: While positive news has been incremental, the market has responded favourably, likely due to the pre-existing bearish sentiment. The avoidance of worst-case scenarios and any positive developments, even if minor, have contributed to the upward momentum

But is the rally in European stocks sustainable?

Historical analysis of similar SX5E squeezes by Barclays reveals mixed subsequent performance.

In some cases, the index continued to rally, while in others, it experienced a correction.

This suggests that the continuation of the current rally is uncertain.

However, analysts at Barclays say the current environment presents some compelling reasons to consider further exposure to European equities:

Attractive Option Pricing: The recent rally has pushed implied volatility levels on EU indices to near 5-year lows, making options relatively inexpensive.

Additionally, call skew, which reflects the relative cost of calls versus puts, has also declined, particularly for shorter-term options. This creates an opportunity for investors to utilise options as a risk-limited way to participate in any potential further upside.

Steepening Volatility Term Structure: The difference between short-term and medium-term volatility, represented by the 6-month to 1-month volatility ratio for SX5E, has increased significantly

This indicates that while short-term uncertainty has diminished, the market is still pricing in a degree of political and policy risk over a longer time horizon.

This suggests potential opportunities for investors comfortable with holding positions for a longer duration.