What Euro Bulls Will Be Watching If Draghi Makes Dovish Turn

  • Positioning data, U.S. rate differential, technical signal
  • ECB may reference currency strength, raising selloff risk

Danny Blanchflower Expects 'Caution' in ECB Decision

A dovish surprise from the European Central Bank could inflict a world of pain on euro bulls.

Betting on the shared currency has almost become a sure thing as overall dollar weakness and speculation that ECB President Mario Draghi could signal his intent to scale back monetary stimulus at Thursday’s policy meeting combined to push it to a 14-month high. That has strategists such as  Shahab Jalinoos of Credit Suisse Group AG concerned.

“Considering how long the euro rally has been in play and the fact that the shorter-term market is likely long, it may be sufficient for Draghi to reference currency strength as a factor for consideration to allow a correction,” Jalinoos wrote in a client note.

Even with Wednesday’s retracement versus the greenback ahead of the meeting, the euro is still up almost 10 percent this year. On a trade-weighted basis, the currency is trading at levels last seen in January 2015 -- just before the ECB announced its quantitative easing program.

With that in mind, here are a few red flags for euro bulls.

Everyone’s Long

As political risks in the euro area stage a retreat, investors have embraced a bullish stance. U.S. Commodity Futures Trading Commission data over the past two months show leveraged funds have upped their positions to “net long” for the first time in three years, while speculators overall are the most bullish since May 2011, underscoring the risks for the shared currency if investors retreat en mass.

Yield Differential

The euro has rallied against the dollar this year even as its yield spread -- the premium investors demand to own two-year U.S. Treasuries versus similar-maturity German government bonds -- stays within a modest range of 200 basis points.

Triple Top

If the currency comes under sustained pressure from a less-hawkish-than-expected ECB meeting, one technical indicator may portend a bearish outcome. Over the past two years, the euro has peaked twice near current levels, suggesting the potential for a reversal of this year’s prolonged uptrend, known as a triple-top formation, if bears are vindicated.

To be sure, a triple top formation only completes when price momentum fully reverses -- and that’s not seen as the consensus outcome for now.

As such, HSBC Holdings Inc., which projects the euro will end the year at 1.2 per dollar, a 4 percent upside from current levels, remains bullish. “The fast money is turning more bullish euro, but does not look stretched or suggest an imminent reversal,” strategists led by Dominic Bunning, wrote in a client note, citing muted bullish positions among reserve managers, among other factors.

— With assistance by Sejul Gokal, and Stefania Spezzati

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