Signal Suggests Short-Term Gains, Long-Term Pain for Euro

The following is a reprint of the market commentary from the October 2017 edition of The Option Advisor, published on September 22. For more information, or to subscribe to The Option Advisor -- featuring 10 new option trades each month -- visit our online store.

It was just a couple of months ago in this space that we touched on the predictive powers of the group of investors known in the weekly Commitments of Traders (CoT) reports as "large speculators." This subset of investors is broadly comprised of fund traders and professional traders, and their collective uncanny knack for mistiming major volatility moves has made them a favorite contrarian indicator of our Senior V.P. of Research Todd Salamone. More often than not, when CoT large speculators are net short CBOE Volatility Index (VIX) futures in the extreme, the VIX has been more prone than usual to big spikes. And conversely, on the rare occasions this group goes net long VIX futures, we've seen volatility retreat.

With this "comedy of errors"-type track record in mind, it was with some interest that we registered a couple of apparent extremes in large speculators' currency posturing in the CoT report released last Friday, Sept. 15. Specifically, this marked the eighth consecutive week of large speculators being net short the U.S. dollar, while the net long position on the euro is approaching decade-plus extremes. On the surface, this diverging sentiment on the two currencies is simply the extension of a "pro-Europe, anti-U.S." investment trend we've been clocking for some time. But under the surface, it's worth questioning whether the current CoT large speculator positioning is sending up any tradable contrarian flags for these two dominant currencies.

To that end, Quantitative Analyst Chris Prybal sifted through our roughly 31 years of CoT data to find some answers. Looking back at dollar returns following previous stretches of eight weeks or more with large speculators in a net short position, there are 26 prior instances to consider -- but not much to go on, in terms of actionable short-term trading takeaways. Following one of these signals, the greenback's average returns lag its comparable "anytime" returns over most time frames, aside from notable outperformance over a year's worth of trading days (+0.9% vs. -0.1%).

So if history holds up, we may see the dollar lag a bit in the immediate weeks and months ahead -- but the below chart serves to reinforce the notion that longer-term gains may be on the horizon. This graph shows the USD net short position among CoT large speculators as a percentage of all positions. Currently, it's at 52% of the total, having moved above the 50% threshold in late July for the first time since June 2014. As you can see, previous moves above this 50% threshold have preceded ramps higher in the dollar's value, with the 2014-2016 greenback surge standing out as particularly eye-catching.

Formal trading of the euro began at the start of January 1999, at a value of $1.1743 in dollar terms -- a price point that could be viewed as tantamount to a stock's IPO price, as it may represent a breakeven level for many long-term investors. The euro's "IPO price" has notably marked the November 2005 low and August 2015 high, and the common currency wrapped up the month of July 2017 by crossing above this level again, following a roughly two-and-a-half year stretch below it.

CoT large speculators currently maintain a net long position of 91,270 contracts on the euro, just off the 10-year high of 100,437 contracts set the week prior. And while the current level of net long euro exposure is inarguably massive, it's worth mentioning that earlier in 2007, peak net long euro positioning among large speculators topped out at 119,538 contracts. So, while this contingent is extremely net long at the moment, there's still room for this trade to get even more crowded.

That said, below is a table summarizing euro returns following previous instances where the net long position among CoT large speculators has climbed above the 50,000 mark. After correcting for redundant signals, we have just 10 occurrences since 1999 -- but the average returns and percentage of positive returns indicate significant outperformance, relative to "anytime" results, over time frames from 10 days to two months following a signal.

Over longer time frames, though, the degree of outperformance dwindles (a trend that's been particularly pronounced in the post-financial crisis era, when viewing the individual signals). And once we get to a full year's worth of trading days after a signal, the euro averages a decline of 3.7%, with only 33% positive returns -- significantly worse than its typical performance. Combining this analysis with that of the U.S. dollar above, it appears that we might expect to see a stronger dollar and a weaker euro this time next year.

On a more immediate basis, however, traders may seek to capitalize on expected euro outperformance over the next few months -- with particular emphasis on the short-term nature of the opportunity window here. At the aforementioned early September peak of net long euro exposure among large speculators, the percentage of net longs was 36% of total positions. That's a far cry from the intensity of the 70%+ readings that were not at all uncommon in 2007 and prior years, which reinforces the idea that this trade has yet to reach "peak crowdedness." But the last time net longs topped the 30% level in the post-financial crisis era, back in 2013, the longer-haul outcome for the euro was markedly bearish.