January 8, 2018 / 11:50 AM / 8 months ago

Commentary: Hedge funds start 2018 with record $19 billion bet on the euro

LONDON (Reuters) - Hedge funds have kicked off 2018 with their biggest bet ever on the euro rising, a clear vote of confidence in the single currency but, with positioning so stretched, one which could backfire in the near term.

Euro banknotes and coins are displayed in a shop in Brussels, Belgium November 14, 2017. REUTERS/Eric Vidal

Data from the Chicago Futures Trading Commission show that hedge funds and speculative accounts ramped up their net long euro positions by more than 35,000 contracts to 127,868 in the week to Jan. 2, a bet worth $19.3 billion.

That’s the largest net long euro position since the single currency’s inception 19 years ago, overtaking the previous high of 119,538 contracts registered in mid-May 2007.

The ‘fast money’ community’s bet on the euro has been a major driver of the currency’s rise. It gained 14 percent against the dollar last year, its best year since 2003 and third best ever.

It’s easy to see why. Positive surprises from the euro zone economy beat positive U.S. economic surprises for much of 2017 (although that trend reversed late last year) and the euro zone economy grew at 2.6 percent in the third quarter, its fastest since 2011.

According to the European Commission, the European economy, the bulk of which comprises the 19 nations that use the euro, grew 2.3 percent last year compared to the United States’ 2.2 percent.

The “euroboom”, as it has come to be known, is one of the most important components of a wider economic upswing that now has world growth closing in on 4 percent.

The euro climbed to a four-month high last week of $1.2089, within a whisker of breaking above September’s peak of $1.2092 which would have heralded a fresh three-year peak.

Analysts at Deutsche Bank, among others, have raised their forecasts for the euro. They see it reaching $1.30 by the end of the year on the back of strong capital flows into the region.

ECB DILEMMA

But with positioning so stretched, the question is whether the euro’s upward momentum can be sustained.

The euro on Monday was down for the second day in a row, something not seen for a month. It was back below $1.20, albeit it only just, and recent history suggests it will be difficult to stay above that level for any length of time without fresh tailwinds.

Much depends on the relative paths of U.S. Fed and European Central Bank monetary policy.

Traders are betting that the Fed won’t tighten too aggressively, while doubts are growing on how long the European Central Bank can stick with negative interest rates with growth so strong and oil prices at their highest in three years.

Yet a strong euro will surely make ECB policymakers think twice about how quickly and aggressively they tighten. A general rule of thumb states that a 10 percent rise in the euro corresponds with a fall of nearly 0.5 percentage points in inflation over the next 12 months.

Annual euro zone inflation fell to 1.4 percent in December, moving away from the ECB’s target of “below, but close to, 2 percent over the medium term.”

The euro’s 14 percent rise against the dollar last year (admittedly only 5 percent on a trade-weighted basis) will help keep a lid on the inflationary pressures being stoked by strong growth and high oil prices.

When positioning was almost as stretched back in May 2007, hedge funds and speculators began scaling back their long positions. So much so that almost a year later they were net short of euros.

But the euro/dollar exchange rate didn’t reverse. It went from around $1.35 at the CFTC peak net long all the way through $1.60 by April 2008, just as global markets were about to come crashing down later that year.

Will a similar pattern be repeated this time around?

Reporting by Jamie McGeever; Editing by Robin Pomeroy

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