Following the global stock market sell-off earlier this month, the euro was quick to recover most of its losses in a short period of time. While other currencies (such as the Australian dollar or the British pound) never fully recovered, there was no shortage of dip buyers looking to go long the euro. Looking at EUR/USD, it took just four trading days to recover to the critical 1.25 level after the pair fell to around 1.2250 in the second week of February. Seeing strong momentum, we upgraded our short-term outlook on the common currency on February 16 accordingly. Unfortunately, this move was only a temporary phenomenon and the currency has since run out of steam. Notably, EUR/USD failed to make a higher-high last week, an indication that sentiment is less bullish today. We expect to downgrade our short-term outlook later this week to neutral. An overview of EUR/USD since 2017 is shown below for reference:

Back to neutral? EUR/USD running out of steam

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Source: TradingView

With technical factors pointing to a more bearish outlook on the currency, it is tempting to suggest that a euro bear market is around the corner. The last time the euro rally paused in October 2017 (following a disappointing ECB meeting and over-extended speculator positioning), the euro resumed rallying by December. While bullish momentum is certainly waning today, other factors remain supportive for a higher euro. In particular, ongoing economic expansion (even following today’s lower-than-expected manufacturing PMIs), monetary tightening expectations and moderate sentiment means that the euro can push higher. Unless economic fundamentals and sentiment point to a weaker euro going forward, we remain mildly bullish on the euro’s prospects.

Expansion looks set to continue, albeit at a slower pace

While economic data from the Eurozone was surprisingly strong last year, figures this year have often come in below estimates. Earlier today, both manufacturing and composite PMIs were below expectations, signaling lower-than-expected future growth. With the latest manufacturing PMIs at 58.5, overall Eurozone growth remains in positive territory. This being said, the consensus expectations were too far ahead of reality.

After a record run, future growth expectations now slowing

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Source: Markit Economics

As can be seen above, manufacturing PMIs began accelerating in late 2016 and continued improving until late last year. Recently, the outlook for the manufacturing has been declining, but continues to expand overall. In a previous commentary, we explained why the performance of the manufacturing sector is an important driver for the euro.

Turning to monetary policy expectations, the European Central Bank’s asset buying program is more likely to come to an end thanks to strong GDP growth. Following the appointment of Spain’s Luis de Guindos as the ECB’s next vice president, a Northern European candidate is widely expected to take the helm of the ECB. Following many years of Mario Draghi’s easy-money policies, monetary hawks in Northern Europe are eager to put an end to policies put in place during the Eurozone crisis. Looking at recent media reports, Germany’s SPD is backing German Bundesbank President Jens Weidmann to become the next head of the European Central Bank. According to Die Zeit (a leading German newspaper), the SPD agreed to support Angela Merkel’s choice for the next ECB president during coalition talks. Weidmann, who has criticized the ECB’s extraordinary monetary policies in the past, is widely expected to tighten Draghi’s crisis-era policies.

No QE needed with 2%+ GDP growth

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Source: Eurostat

As can be seen above, Eurozone GDP growth has accelerated to a significant degree in the past few years. As perceived political and economic risks have subsided significantly, the ECB is running out of excuses to maintain its current asset buying program. Even with a moderate slowdown, expectations are rising for the Bank to end its asset buying program in the second half of this year.

Bullish euro less of a consensus trade thanks to volatility

The last factor to consider is sentiment. As we wrote in our take on last week’s Commitment of Traders report, recent volatility has stopped out many traders from their long euro bets. Looking at last week’s figures, the number of net long futures and options contracts on the euro fell by 13,274 contracts. Following the change, the net long position in the euro is no longer at a bullish extreme. Looking at the number of net long positions as a proportion of open interest (20%), also suggests a clear path ahead. Prior to the recent sell-off, we warned that long positioning in the euro was at a bullish extreme. Net positions and positions as a proportion of open interest are shown below for reference:

Volatility scares away the long euro crowd

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Source: CFTC, MarketsNow

As can be seen above, the number of net long contracts in the euro has grown over the past year. In January 2018, net long positions as a percentage of open interest jumped to 22%+ (an extreme based on historical averages). Following a recent bout of volatility earlier this month, the number of long euro positions have fallen. As such, the position is no longer at a bullish extreme and has room to keep building.

Euro no longer a slam dunk, but not a sell either

The big macro trade in 2017 was going long the euro (or going short the US dollar index). Following a significant move, it’s unlikely that the euro will keep strengthening at a similar pace going forward. While many are looking to call the euro top (and some already have), our view is that most factors point to a stronger euro going forward.