EURUSD vulnerable to squeeze in heavily short market

Data on positioning and risk-reversals indicate that the mood surrounding EUR is at its lowest point this year. CFTC data among non-commercial traders has shown the largest net-short EUR position since June 2010 and three-month EURUSD 25-delta risk-reversal, skewed at –4.0%, are almost double their average skew since mid-April 2010.

Analysts are suggesting this level of pessimism may be excessive in the near-term and has opened the potential for euro short squeezes when better-than-expected eurozone news arrives. RBS’s short-term cyclical model, combining implications from rate differentials, risk appetite and sovereign risk, has indicated fair-value of EURUSD at over 1.37. Analysts at the bank say this suggests there is potential for the squeeze that emerged in Wednesday’s European session to continue higher, particularly as short-term positive news such as steps towards a European Financial Stability Facility ratification might continue to take some pressure off the euro.

EURUSD opened at 1.3570 in the European session and encountered a sharp rebound, reaching highs of 1.3680, on the back of encouraging comments from Chancellor Angela Merkel on Germany’s support for Greece and after the EU commission said the tripartite committees of the EU, ECB and IMF will arrive in Greece on Thursday.

Traders at a top-five bank indicate morning order flow was skewed slightly in favour of euro buying, but say much of the rebound was simply the result of the market being caught heavily short. “The moves are largely being driven by positioning,” says one. “The market was very short; even mildly positive news from the eurozone initiated a fairly sharp bounce higher, exacerbated by stops triggering around the 1.3650 mark”

Today’s move shows just how disproportionate price action can be after eurozone developments. “Right now, the market is asymmetric in terms of its reaction to news,” says Geoffery Yu, FX strategist at UBS. “If we get bad news on a scale of 7, the impact will probably be 1, but when there’s good news on a scale of 1, the impact will probably be 7. That is the way the market is operating right now.”

Robert Sinche, head of FX strategy at RBS, says that he expects further short squeezes but warns that any recovery is likely to be short-lived - the likelihood of a eurozone recession in 2012 has risen and economists forecast the ECB to cut rates by 50bp as soon as October. The continued delay in decisive action by policymakers also weighs on the euro. Sinche advises that while he is lowering three-month EURUSD forecasts, investors should be cautious of further short squeezes if the market remains heavily short.

“We believe there will be a good entry level for core short positioning during the weeks ahead, but would wait for more neutral readings on positioning and risk-reversals before initiating that exposure,” says Sinche.