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Time for EUR to Re-Visit Reality

EUR has soared vs. most major currencies over the past several months despite the Eurozone having its share of problems: Several major member economies are struggling under a heavy debt load, without being able to control their own monetary policy to help them unload some of it. Interest rates are high as investors shun the sovereign debt of these nations. With the ECBs planned rate hike tomorrow (April 7, 2011) already pretty much a done deal, and investors pricing in almost 100 basis points by the end of 2011, this debt burden can only get worse - unless of course the European Central Bank doesn't follow through completely.

If an aggressive series of rate hikes is already priced in, and if those hikes are likely to cause political discord within the Eurozone, as well as drive several major memeber economies towards default, we may just have an inefficiency in the market - price is based on information that is unlikely to materialize. What we are suggesting is that if the ECB hikes rates tomorrow, as it appears inevitable, they may very well come out with a more dovish statement. They will hike in order to let the markets know they are serious about their inflation-fighting mandate, but at the same time, it would be imprudent of them to bury the peripheral nations which are wallowing in their debt (namely Greece, Ireland, Portugal, Spain, and even Italy may be included in this group). So the way I see this playing out is with a single hike tomorrow, and perhaps another 25 basis points by end of 2011, if that. Anything more would be suicide for the Eurozone (Trichet himself has warned the markets that one hike does NOT mean a series of hikes). Even if it does happen, in the medium to long term, I don't see any further hikes bidding up EUR from here, as the ECB cannot possibly be more aggressive that what the market is pricing in right now. There is simply not much further upside, and lots of downside, depending on how the debt crisis plays out.

This all points to one thing if you are a forex trader - EUR is way overpriced above 1.4200 vs USD. With the Federal Reserve probably winding down QE operations in the following 2 months, and with several members already becoming somewhat hawkish on rates, it would seem that shorting EUR/USD might be our other trade for 2011 (besides our USD/JPY long position).

UPDATE (08-05-2011): We showed up to the party a little early, but that only results in us getting in at an even better price (although we suffered a lost trade). Reality seems to be finally hitting the EUR, as Greek default seems inevitable. How far the domino effect of higher rates and further defaults in the Eurozone will take us is anyone's guess, but the safe haven of USD seems a likely beneficiary, particularly so if the US economy is able to weather the ordeal better than the rest of the world, which is again likely. It is quite reasonable to expect EUR/USD to continue its downward spiral to the 1.1900 lows from 2010, and most likely even lower in the coming months. The move is also likely to be quite violent.

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