Buy EUR/USD On the Next Dip say Morgan Stanley as Europe’s Stars Align

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The stars are aligned for the Euro to keep marching higher this year and recent volatility means speculators just may get the chance to pick up the single currency on the cheap this February.

The Euro-to-Dollar rate is likely to renew its Northward march during the weeks ahead, according to strategists at Morgan Stanley, who say that recent events in German politics should further strengthen Eurozone economic fundamentals.

Morgan Stanley strategists have recommended that clients prepare to pile into the EUR/USD should February’s downward correction extend further, in what is a classic example of a “buy on dips” approach to trading.

They just might get to do this if strategists at other banks are right in their predictions that recent volatility in global stock markets will lead to a deeper fall in the EUR/USD rate over the coming weeks.

The EUR/USD was already buoyed to a double digit return in 2017 by a stronger economic recovery and expectations that the European Central Bank will soon normalise its monetary policy.

This rise has continued into 2018, with the currency pair up by 2.99% in the weeks to February 12, although the Euro has eased back by a touch in February and created scope for clients of banks like Morgan Stanley to add to previous bullish bets.

“The announcement of a CDU-SPD coalition agreement in Germany should support the prospect of European integration further and reduce risk premia, while bolstering continued FX unhedged inflows,” says Hans Redeker, head of G10 FX strategy at Morgan Stanley, in a recent note.

Faster Growth and a Stronger Euro

The main catalyst for further gains in the Euro-to-Dollar exchange rate are expectations of even faster economic growth across the Euro area, following Chancellor Angela Merkel’s deal to create another so called “grand coalition” government in Germany.

In order to get the deal done Chancellor Merkel’s CDU party has agreed to relax Germany’s purse strings, which means more fiscal spending in Europe’s largest economy. The agreement is also seen fostering a renewed push by both Germany and France to deepen Eurozone integration.

Both of these factors are seen by economists as being positive for European economic growth, although a vote of approval from the junior SPD party’s membership is still required in order for the coalition government to be finalised.

Morgan Stanley’s Redeker says this should help drive further “unhedged inflows” into the Eurozone, which were already a key driver of gains for the single currency in 2017.

“Unhedged inflows” means international investors bringing money into Europe without protecting themselves against a fall in the currency, presumably because they also have a positive view of where the currency will go over coming years.

When investors do protect themselves however, they sell the EUR/USD rate at the same time as they buy it, which protects them against a fall in the exchange rate but also prevents currency appreciation as one transaction counteracts the other.

“Economic data in Europe continue to surprise to the upside, most recently seen in the services and composite PMIs, which keeps expectations for euro area growth high,” Morgan Stanley’s Redeker adds.

“Meanwhile, we continue to project USD weakness over the longer term, with strong global growth aiding USD weakness as USD funding for foreign investment continues to rise.”

Redeker and the Morgan Stanley team recommend that clients of the bank wait until the EUR/USD falls back to 1.2165 before piling in, placing a stop loss at the 1.2050 level and targeting a move up to 1.2800.

Volatility Augurs EUR/USD Downside in the Short-term

The EUR/USD rate was quoted 0.42% higher at 1.2352 during late noon trading in London Tuesday, which leaves some 200 points downside before Morgan Stanley’s trade goes live. There are grounds to think the Euro could actually fall that far against the Dollar over coming weeks too.

After all, Morgan Stanley’s trade idea follows a week of mounting fears over a sudden increase of global inflation and interest rates that sent the VIX index, which is a “fear gauge” that measures volatility on the S&P 500 index, surging by more than 150% in a single session. It’s largest single day rise on record.

Strategists at J.P. Morgan have studied previous instances where the “fear gauge” VIX index suffered a similar shock to the one delivered last week and, after crunching some numbers, have found there could now be considerable implications for currency markets in the short term.

“In historical instances when VIX surged above 35, in all instances [institutional money manager] positions were cut both on the long and short side (vs USD), on average a third over two weeks, and cumulatively by a half in the month following the spike,” writes, Daniel Hui, a strategist at J.P. Morgan, in a recent note.

The VIX “fear gage” rose to the 50 level last week, substantially over and above the 35 threshold in J.P. Morgan’s analysis, which suggests those currencies that have seen large bullish bets placed behind them in recent weeks, or even large bearish bets, could be prone to a reversal.

“Currently positioning shows the biggest longs in EUR and GBP...The biggest shorts are in USD, JPY, and CHF,” says Hui.

This suggests the Euro could be prone to a fall during the weeks ahead and that the US Dollar may due a resurgence of sorts. Readers can learn more about the J.P. Morgan analysis here.

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