Euro’s Strength May Just Be Prelude to a Big Trend in the Making

(Bloomberg) -- The forces behind the euro’s recent strength suggest this may only be the first stage of a big market shift.

The currency’s 3% rally this month to near $1.16 has come on the back of dollar weakness due to narrowing bond-yield differentials and the U.S. struggle to deal with the pandemic, as well as the prospect of increased cohesion in the European Union after its agreement on a recovery fund.

These factors remain very much in play. Yet what makes the case for the rally to extend further is that market positioning remains largely underweight on the euro. A structural shift in investor exposure would mean the trend has just begun.

Hedge funds are still rushing to cover short exposure in the spot and options market, while institutional investors have just started to add long positions, according to traders in Europe, who asked not to be identified because they are not authorized to speak publicly.

According to the latest data from the Commodity Futures Trading Commission for the week through July 14, asset managers increased their long positions to over 300,000 contracts, while leveraged funds were short by more than 32,000 contracts.

The fact that traders are essentially covering cash shorts is shown by price action in the euro-dollar pair. Any corrections have been shallow and the fear of missing out in rallies has seen investors rushing to buy fresh highs.

There’s a similar picture painted by risk reversals, a barometer of options positioning and sentiment, in the euro versus currency havens. Bearish sentiment in the euro versus the yen through option trades is now at its lowest level since early 2018, while against the Swiss franc the market started betting on gains last week.

This means there is plenty of room for the common currency to rise should the EU keep handling the pandemic effectively and if the economic recovery in the region keeps defying initial expectations.

Technical charts and commercial investor positioning also point to a continuation in the rally. Momentum could take the euro above $1.18, with the dollar at risk of a deep drop in coming months.

According to CFTC data commercial investors, who are looking to hedge and thus trade in the opposite direction to anticipated price action, are adding more and more euro short positions. Historical patterns suggest that will be followed by the euro strengthening.

• NOTE: Vassilis Karamanis is an FX and rates strategist who writes for Bloomberg. The observations he makes are his own and aren’t intended as investment advice

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