FXE: Stay Short The Euro On Weak Eurozone Economy

A few months ago, I recommended investors short the Euro (EUR:USD), as economic fundamentals continue to diverge between the Eurozone and the United States. Since my article, The Euro has depreciated 3% against the US dollar, one of the weakest performances of the major currencies (Figure 1).

This article examines recent news involving the Euro and whether investors should continue to be short the Invesco CurrencyShares Euro Currency Trust ETF (NYSEARCA:FXE).

Fund Overview

First, for those not familiar with the Invesco CurrencyShares Euro Currency Trust, the FXE ETF is designed to track the price of the Euro in US dollars. The FXE ETF allows investors to easily gain exposure to the Euro against the US dollar without having to open an FX brokerage account or pay FX conversion fees. The FXE ETF has $236 million in assets and charges a 0.40% expense ratio.

Dovish Hike, Is The ECB Done?

In terms of news directly impacting the Euro, the most important has to be the European Central Bank's ("ECB") recent decision to raise its policy rate by 25 bps on September 14, 2023.

Normally, when a central bank raises interest rates, its currency should appreciate, as higher interest rates make holding the currency more attractive vis a vis other currencies. As I have detailed in prior articles, the relatively faster pace of interest rate increases in the Eurozone was the main reason the Euro appreciated against the US dollar since the Fall of 2022.

However, this time around, the Euro's reaction has been very muted, despite the ECB raising policy rates to 4.0%, the highest since the common currency was created (Figure 2).

The market's muted reaction is because, according to many pundits and policy watchers, this was a 'dovish hike' by the ECB. Although the ECB raised interest rates by 25 bps, they also hinted that policy rates have reached the ECB's target levels and that the ECB would be pausing indefinitely:

Based on its current assessment, the Governing Council considers that the key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target.

- Quote from ECB policy decision statement, September 14, 2023

The ECB is caught in a tough position. As I mentioned in my prior article, the Eurozone's economy is fundamentally weaker than the U.S. and thus cannot support the same level of interest rates. In fact, we are starting to see signs of the Eurozone economy slowing significantly from the effects of prior interest rate increases, with Germany, the Eurozone's powerhouse economy, experiencing 2 straight quarters of GDP contraction recently in Q2 (technically, a recession) (Figure 3).

Germany is not an isolated case, as the EU itself barely grew in the 2nd quarter and multiple members experienced YoY declines in GDP (Figure 4).

With the EU possibly entering a recession in the next few quarters, traders are now speculating the ECB may have to cut interest rates soon to spur growth.

US Economy Far Stronger Than Eurozone

At the same time, the U.S. economy continues to power along with 2.1% YoY GDP growth in the second quarter, and a possible reacceleration in the third quarter to above 4% growth, if the Atlanta Fed's estimate is to be believed (Figure 5).

Therefore, although investors also widely believe the Fed will pause its interest rate hikes at the upcoming FOMC meeting on September 20th, the chances of interest rate cuts in the U.S. in the next few months are much slimmer than in the EU (Figure 6).

Euro Oversold, But Fundamentals Remain Bearish

Technically, the Euro broke down from the wedge pattern that I highlighted in my last article, recently hitting the 1.06 level (Figure 7). On a short-term time horizon, the Euro is deeply oversold and may be prone to sharp reversals.

However, given the economic divergence between the Eurozone and the U.S., I continue to believe there is more downside to the Euro in the coming months.

Trapped Longs Need To Get Out

One area traders should monitor is futures positioning, where we can see that speculators are still very long the Euro. As the Euro continues to lose steam over the coming months, there is a large risk of speculators rushing for the exits (Figure 8).

Consider Taking Profits And Rolling Options Further Out

In my prior article, I recommended investors short the FXE ETF via options. At the time, I noted the 100/95 December put spread on the FXE traded at a $0.70/$0.95 (bid/ask spread) with a maximum payout of $5, for a >5:1 reward/risk ratio (Figure 9).

Investors who entered the put spread have seen its value roughly double in price to trade at $1.65/$1.85 (bid/ask), so investors may want to take some profits off the table and roll the strikes lower or further out in time (Figure 10).

For example, investors can consider selling the put spread and rolling to be long the $97 strike puts, which is trading at $0.60/$0.75 bid/ask. Essentially, traders can get back their initial capital ($0.95 from the initial put spread), and own downside below $97 for 'free' (Figure 11).

Alternatively, investors can consider rolling out to the March 2024 expiry with a 97/92 put spread (Figure 12), which is trading at $0.70/$0.90 bid/ask.

If I am correct that the Euro ultimately has downside to parity, then the equivalent level on the FXE ETF is $92 (Figure 13).

Conclusion

My call for a weak Euro has played out exactly as envisioned as economic fundamentals have diverged between the Eurozone and the U.S. Investors who took my advice and shorted the FXE via put spreads can consider taking some profits, as the Euro is deeply oversold. However, I believe the fundamentals still call for a lower Euro over time. I remain short on the FXE ETF.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.