How to Profit from the Euro

By Evaldo Albuquerque, Editor, Exotic FX Alert and Currency Capitalist

Dear Sovereign Investor,

Here’s a sure way to make money – the world’s best investors and traders follow this simple rule:

Buy low, and sell high.

The rule seems simple enough, but few people are able to follow it. Generally, it requires going against the crowd – which, of course, is much easier said than done.

Most people feel safer going along with the majority, but the truth is that the most profitable trades are usually those which go against the grain.

Today, shorting the euro is one of the most crowded trades in the financial markets. So should you go against the crowd and buy the euro?

Before we answer that, first we need to take a look at what being a contrarian really means.

The Art of Being Contrarian

Only a small handful of people understand what it means to be a contrarian investor or trader.

For a start, it’s not just about moving in the opposite direction to everyone else. There’s no point in going against the crowd just for the sake of it.

The crowd is actually correct most of the time.

But my experience has shown me that it’s the turning points where most people get things wrong.

So just because everyone is bearish on an asset doesn’t mean it will soon rally. And just because everyone is bullish on an asset, it doesn’t mean it will soon crash.

The most important thing is timing… in other words, when to go contrary. And, for that, you need to be able to justify your contrarian view with a logical and well-reasoned argument.

Let’s apply this idea to the most crowded trade in the Forex market -— the euro.

Finding the Right Turning Point

Everyone hates the euro now.

According to the latest data from the Commodity Futures Trading Commission, bets in the futures market against the euro are now at an extreme level.

Hedge funds and other large speculators have 113,697 more bets that the euro will fall against the dollar than gain on it.

That’s a net-short position similar to what we had back in May 2010, during first episode of the Greek crisis. In June, the euro started a massive, multi-month rally that pushed the currency up by more than 24%.

That’s the perfect example of how the crowd was wrong at a turning point. Is the crowd wrong again this time? I believe the chart below holds the answer.

One Number Holds the
Key to the Euro’s Future

This number is probably the most important driver of financial markets these days. It’s important not only for the euro, but for commodities and stocks across the globe.

I’m talking about the yield on Italian bonds.

The yield on 10-year bonds, for example, has been trading very close to the critical 7% level. Such a high borrowing cost is not sustainable.
It also suggests the latest measures taken by the European Central Bank have not increased confidence in the European bond market.

Italy’s Higher Borrowing Costs is Pushing the
Dollar Up, and the Euro Down

The chart above shows the yield on Italy’s 10-year bond and the performance of the fund UUP. This ETF measures the performance of the US Dollar against six other major currencies. So it’s a good way of measuring the strength of the buck.

Notice that during the first half of 2011, Italy’s borrowing cost was pretty stable, with the yield trading below 5%. The dollar was in decline during that period, while the euro was rallying.

But the yield on Italy’s bond started to get out of control back in September, moving quickly towards 7%. Since then, the fund UUP has rallied about 6%.

When to Strike in 2012

Everyone loves the dollar, and hates the euro. So is now the time to go against the crowd by shorting the dollar and buying the euro?

I don’t believe it. There’s no question shorting the euro is a crowded trade. But it’s a trade that can be backed up by facts.

The high yields indicate the problems in Europe are not solved. As long as borrowing costs remain elevated, the euro will most likely remain under pressure.

So I don’t think it’s time to go contrary on the euro trade — at least not just yet.

Sure, we could see a short-term rally, perhaps up to 1.33. But I suspect there will be a lot of selling pressure around that level.

I would use any rallies to establish fresh short positions.

In May of 2010, when a short position in the euro was also at an extreme, the currency fell another 5% before rallying. With the maximum leverage available in the Forex market, that’s a move of 250%.

Remember, the crowd is right during the trend, but often wrong at the turning points.

The euro remains in a downtrend, so it’s not time yet to go against the crowd. We will start 2012 with a weak euro and a strong dollar.

Best Regards,

Evaldo Albuquerque
Editor, Exotic FX Alert and Currency Capitalist