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“Those who have knowledge, don’t predict. Those who predict, don’t have knowledge. ”

Lao Tzu, 6th Century BC

Commentary & Analysis

Euro is an Overvalued Momentum Trade – Equation #2 Says So

On Tuesday I shared with you an equation which sufficiently explained why capital flow was a valid rationale for the rally in the euro against the US dollar.

But what if the capital flow equation was simply an analytical fit to a flawed story?

I ask because there is another equation I want to share with you today. And I believe it boils all this stuff to its essence: Sentiment based on our flawed forecasts of the future.

“Expectations relate to expectations and the prevailing bias can validate itself almost indefinitely.”

George Soros, Alchemy of Finance

The currency equation of expected total return:

↑Expected Total Return = ↑Interest Yield + ↓Inflation + ↑Future Exchange Rate

This equation says the primary rationale for holding a particular currency is to maximize total return, and expected total return is a function of the real yield achieved (nominal interest rates minus the inflation rate) and the future exchange rate (that which we are trying to forecast).

We know higher real yields and rising exchange rates attract speculative capital flow. It only makes sense; but logically isn’t it circular reasoning?

In other words …

Do rising real yields cause the exchange rates to rise … or is it a rising exchange rate, impacting the fundamentals, which forces interest rates to rise?

Remember, in the real world economics is filled with feedback loops rarely discussed by academics or those who fall in love with their stories. This is why it is so painfully difficult to determine which variables lead and which follow.

A second problem with the equation above is this: We cannot forecast interest rates. Period.

“There is an old Sufi tale about a mullah (Nasruddin) who was discovered by a passer-by searching in the dust outside his house. What was he looking for, the stranger enquired. A key, said the mullah. Where did he drop it? “In the house” replied the mullah. Then why was he looking in the dust outside? Because here he was in bright sunlight, whereas in the house it was dark and difficult to see.

“It happens to us all the time. The solution to worthwhile problems is never out there in the open. The key to financial markets is elusive. It must be so – by definition. The price-discounting mechanism ensures that the majority are always looking out there in broad daylight, when the key is somewhere else, in the shadow.

John Percival, The Way of the Dollar

So, we started off with a seemingly simple and sensible equation. But in this short time I think I have shown it is neither simple nor sensible.

So where does this leave us?

I am not sure where it leaves you. But it leaves me with this conclusion:

Currency trading, unlike other asset classes, is primary a sentiment-driven vehicle. [John Percival recognized sentiment should be the primary focus of currency analysis decades ago. It took many bumps and bruises and self-proofs in the way of lost money for it to sink in deeply with me.]

And though we should monitor things like yield differential and economic growth and capital flows closely, we should not attempt to forecast that stuff. Let others do all the forecasting. We need only concentrate on two things: 1) the consensus rational and 2) potential for surprise to the consensus rationale.

“Our success or failure will rest on our ability to anticipate prevailing expectations and not real-world developments.”

George Soros, The Alchemy of Finance

Let’s use the euro as an example …

It seems the consensus if focused on capital flow, as I discussed on Tuesday. But at some point fairly early in the latest leg up in the euro, which I measure from around July 2013, conversion flow to this rationale was becoming publicly known.

Rationales tend to grow stale, as we all know they don’t last—things change over time no matter how “correct” the rationale was early in the trade. When these rationales grow stale it doesn’t mean the trend is over. For higher prices tend to beget higher prices (and vice versa to the downside) precisely because players become more confident in their stale rationale and add to positions. Plus, pure price led traders hop on for the ride.

A simple self-reinforcing trend, which includes rising prices (in this case for EUR/USD) and rising sentiment, is seen in increased positioning.

Assessing this is the part which Soros talks about, i.e. “our ability to anticipate prevailing expectations.” Once again, even if we know a rationale is stale, it doesn’t mean we can predict when the trend will end. But we can remain wide open to new information and watch the technical character of the market (key days; confluence resistance on wave analysis; divergence in momentum, etc.). And we can create scenarios of potential new rationales that might emerge, and trigger a change in sentiment and the start of a new trend in the opposite direction.

In the case of the euro, the potential new rationale is actually a tried and true rationale. Traders have used in the past – it is yield differential.

Maybe yield differential is that fundamental measuring rod that helps us determine when a momentum trade on a stale rationale is long in the tooth. Below is the current example which I shared with my Black Swan Forex clients this morning. [Note: We got short the euro today before the ECB announcement. Not always the smartest thing to do given whipsaw potential, but it is working nicely so far].

I have shared this chart in the past, and the divergence has grown since then:

Eurozone vs. United States: 2-yr Benchmark Yield Spread (purple line) vs. EUR/USD (green line)

Will traders switch back to this rationale and abandon the momentum trade on capital flow? That I don’t know. But, based on the chart below, I like the potential …

If the EUR/USD trend is changing, guess what: Yield differential and the future exchange rate will ensure you a higher total return if short.

See how easy this is?