EUR/USD Trade Goes Wrong

Strategists have been stopped out of their short EUR/USD trade recommendation having been surprised by the US Dollar's recent rally. 

Strategists at UniCredit Bank have confirmed they have exited a trade that sought to take advantage of further gains in the Euro against the Dollar. 

The trade was closed following a bout of unexpected Dollar strength that pushed EUR/USD below levels which strategists were no longer confortable staying in the market, yielding a loss of 1.55%

"We have been caught wrong-footed by this USD rebound. We thought that the Dollar rally would be briefer and shallower. As things currently stand, USD appreciation has extended beyond what we were expecting," says UniCredit's Co-Head of Strategy Research & Head of FX Strategy Research, Dr. Vasileios Gkionakis.

Why has the recommendation that sought to benefit from further Euro strength and Dollar weakness failed?

Firstly, 'Dollar shorts' had been very stretched across the board, and although there is not very strong evidence of a contrarian pull-back from extreme positioning in USD, it seems in this case the extreme oversold conditions of the currency probably caused a 'short-covering' effect.

Short-covering is when a lot of traders have sold short a currency which unexpectedly bottoms and bounces.

During the bounce the traders holding the shorts get worried and decided to close their positions, which in trading lingo is called 'covering shorts'.

Often executed in a panic as prices rise and traders see their positions rapidly turning from profit to loss, short-covering adds impetus to the early stages of an uptrend.

The second reason for the Dollar's strong recovery is "dollar bulls getting somewhat excited about tax reform," says Gkionakis.

However, he remains skeptical on tax reform saying the evidence from past performance at implementing policies does not hold out much hope for this one in particular.

In addition, there is a massive question mark as to where the money for the tax cuts will come from.

"Even if a very comprehensive plan were to be announced, nothing would guarantee its final shape, let alone approval by Congress. And in reality, financing a sizeable corporate tax cut to 15-20% alongside substantial relief for households is a significant challenge – to say the least – especially following the “fiasco” of the attempts to repeal and replace Obamacare," said Gkionakis.

Yet since all of Trumponomics has now been priced out of USD there is a risk that some of it could get priced back in.

Finally he sees market repricing of the more hawkish Fed which is more confident of raising interest rates in December.

Nevertheless there is a limit to how much higher the Dollar is likely to go as a result of tighter policy.

The US Dollar is already overpriced compared to the level attributable to real yield differentials and the Fed would have to pursue an exceptionally aggressive tightening policy for them to catch up.

Even their current more-hawkish approach is not aggressive enough to warrant the level of the Dollar, so there is actually a risk the currency could weaken, however, Gkionakis says this is overshadowed by the "confluence" of other factors supporting the Greenback.

"So near-term USD gains could well continue. However, we maintain the view that we have not seen the end of the dollar’s (long overdue) downward correction, especially now that flows seem to be returning to the euro area. The implementation of substantial US tax reform represents currently the main risk to our view.," he concludes.

Market Distortions Supporting the Dollar

The Dollar is also gaining support from another less likely source accorrding to the original ideas of one particular analyst Commerzbank's Ulrich Leuchtmann, and that is inefficiencies in the Forward FX market.

The inefficiencies mean that there is a loophole which traders can use to benefit from a risk free profit from the carry advantage of a currency swap because forward contracts are not priced properly.

The inefficiency, allows traders to conduct profitable, risk free, interest rate arbitrage in EUR/USD (but also other EUR pairs) which favours Dollar holdings and leads to downwards pressure on the exchange rate, says Leuchtmann:

"There is increasing evidence that this distortion of the forward market is also having an effect of the spot market. The explanation is simple: Due to a falling EUR-USD basis the carry advantage of EUR-USD shorts is increasing."