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The Crowd Sometimes Gets It Right

Authored by Kevin Muir via The Macro Tourist blog,

Over the past quarter, the Euro currency has rallied a little more than 9%. It’s been a steady slog higher, with barely a pause.

Have a look at the ranking of the major currencies’ performance against the US dollar over the past few months.

It’s all Euro (or pseudo-European) currencies at the top.

And this hasn’t gone unnoticed by traders.

Back in April, speculative traders were leaning short the Euro. But that’s changed, and now the net spec position of Euro currency futures traders at the CME is sitting at the highest level since 2010.

It’s suddenly de rigueur to be all bulled up about the Euro.

And I am sure you can see where I am going with this… After all, something is straight up on a stick, speculative positioning is at extreme levels - of course I am going to be an idiot and try to short it.

Yet, as some of my more astute readers have correctly noted, just because the Commitment of Traders (COT) report is showing extended speculative positioning, doesn’t mean they will be wrong.

Yeah, can’t disagree. Shorting something because it has risen a long way is just plain amateur hour, even if the trade appears crowded. Sentiment extremes only matter at turning points. During the meat of the move, the specs often get it right.

Or at least that’s what we’ve been taught. Yet, I can’t forget all the times over the past few years when I let a good trade (that happened to be crowded) “cook” because of this wisdom, only to find it fall back in my face. If we are indeed at the start of a major EUR move, then I concede that the EUR will become technically overbought, the specs will get long (and only become longer) as the trade relentlessly rises.

But I am not so sure we are about to embark on such a prolonged bull market. I think it is much more probable that the US dollar chops around in the next few months. And if that proves to be the case, then this scenario offers a compelling short opportunity.

Especially when you consider that the EUR currency seems to have run ahead of one of my favourite measures, interest rate differentials.

The German 10 year bund/US T-note spread has recently been tracking the Euro currency quite closely. But that relationship has bent a little during this recent period of EUR strength.

As many of you are aware, one of my favourite trades is short German bund futures/long US t-note futures. The yield spread has risen from the absurd 235 basis points to 172 bps, but I think it still has some room to run.

I am combining these two trades, shorting EURUSD into this spike, but also adding to my short bund/long T-note position.

If you have a look at the regression analysis over the past couple of years, the EUR overvaluation becomes obvious.

There is nothing saying this relationship cannot change. If we are about to enter into a secular monster EUR bull market, then this spread will most likely blow out. But again, I am betting we aren’t about to experience that sort of dramatic shift (at least not yet).

I was looking for an excuse to add to my short bund/long T-note position, and shorting Euro against it looks like the perfect reason. Now maybe I am getting too cute. Maybe I will get my ass handed to me fading this sort of strength. But I just can’t help it. I hate crowded trades, and when I see a chance like this, I need to write some pink tickets.

When the EUR continues to rally in my face, feel free to remind me that the crowd sometimes gets it right.