Yesterday China released news that its foreign exchange reserves increased to $2 trillion! This is a gigantic number and I’m surprised why it was all »»]]>

source: ecb.int

Yesterday China released news that its foreign exchange reserves increased to $2 trillion! This is a gigantic number and I’m surprised why it was all over the news wires and bank reports yesterday but everyone seems to have forgotten it today. Perhaps earnings of big banks like JP Morgan are more important. It’s no wonder now why China had been pushing a switch to a new global reserve currency instead of the dollar and started proposing SDRs (special drawing rights) as an alternative. The country simply has too many dollar assets and needs to diversify. The Euro climbed yesterday to above 1.41, but I many reports are asserting that this move was due to renewed risk appetite in the markets rather than the diversification. I don’t know how serious the market is taking this news, but it certainly seems like an imbalance is developing in the dollar, and I would make a case to consider Euro strength. Consider the following arguments for Euro strength:

1. China has the largest US dollar reserves in the world and is looking to diversify. The next currency in line would be the Euro due to its liquidity.

2. The FOMC yesterday showed more signs that recovery is closer than they originally thought. They stated in the April meeting that “weak sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories, fixed investment, and staffing,” however in the June meeting added, “…but appear to be making progress in bringing inventory stocks into better alignment with sales.” Further, instead of simply stating that economic activity ”is likely to remain weak for a time,” they added in the most recent statement that ”policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.” This increasing focus on recovery means that the market will start to worry less about the recession and more about debt and inflation caused by quantitative easing and stimulus packages on top of the already large debt. The market will start to sell off US treasuries in anticipation of the Fed raising rates to attract capital, and this could hurt the Dollar substantially.

3. There hasn’t been so much diversification talk in recent times (perhaps when Kuwait moved off the dollar peg in 2007 came close). Medvedev brings some newly minted “World Reserve Currency” coins, China urges the world to move away from the dollar, Japan gets involved in verbal intervention to support its US treasury holdings, and traders get out of positions close to the G8 meeting– If something significant happens regarding diversification it’s going to be in the near future (months to a few years)

4. The Euro has been ranging for a month while economic indicators have been surprising in both directions and other macro markets such as stock indices and oil have been making large moves. Volatility is underpriced in the EUR/USD pair and if a move starts developing it may explode. I would advise being long gamma, not short gamma on this pair.

This is not advice to go immediately buy the Euro. If it falls tomorrow or over the next month then don’t blame me. What I’m saying is that there is an imbalance here and what we need is a sentiment shift to reinforce a long bias. The way we trade is to make intelligent choices for bias (i.e. have a good reason), put small positions on when sentiment goes our way, and then add to that position when things really start moving. So far I have a small position on in the low 1.40s and will see if this continues to develop nicely. If not, no big deal. We’ll wait for the next opportunity.