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Positions in Europe: Short EUR-USD (FXE); Short Italy (EWI)

The currency pair EUR-USD remains a volatile trade as every rumor on Europe’s next move to limit its banking and sovereign risk significantly jolts the pair.  Yesterday from a quantitative set-up, the EUR-USD was not able to breakout back above $1.34 which we took as a shorting opportunity. Since early September the EUR-USD has been broken TAIL (long-term duration), and broken TREND (intermediate term), an explicit short-selling signal in our models (see chart below).

Traders may well be betting that concrete action could come from this weekend’s meeting between Merkel and Sarkozy on Sunday to discuss bank finances ahead of the EU summit on OCT 17th (and hence today’s intraday bounce around $1.35), however it’s worth pointing out that any coordinated policy action will need the blessing of the other Eurozone member states, the ECB, and Brussels. While we don’t rule out a possible swift resolution, it probably won’t come this weekend.

It’s worth noting that while we’re not calling for the EUR-USD to hit $1.20 tomorrow, uncertainty on the region’s go-forward policy to contain or limit its banking and sovereign debt risks—either through a multifactor “bazooka” program or some form of Eurobonds and increases in the ECB’s SMP, for example —should incrementally weaken the pair until some form of “clarity” on policy decision is reached.

From a timeline perspective, it’s anyone’s guess on when Europe’s next band-aid will come—however we’re betting that something is in the pipe. A recent quote from European Commission President José Barroso suggest that Eurocrats are coming to terms with the market implications of their policy schedule: "Markets are much faster than our governments and our parliaments. We have to respect the rhythm of democracies, but I think in extraordinary times we must ask for an extraordinary effort.”

We’d expect any policy action to likely come after all member nations vote on the EFSF, which is expected to come by mid-month (Slovakia and Malta must still vote). Below is a calendar of the near-term events around which policy measures could be crafted:

Oct. 13: Euro-zone finance ministers expected to meet, to decide on release of Greece's next aid payment

Oct. 14-15: G-20 finance ministers' meeting. Europe expected to face pressure to act faster on the debt crisis

Oct. 17-18: EU summit to discuss reform of euro-zone economic governance

Matthew Hedrick

Senior Analyst

Shorting EUR-USD (FXE) - mich