Euro plunges on Portugal Downgrade

Well it was only a matter of time and today it occurred. Fitch downgraded the debt of Portugal from AA to AA-. Fitch cited the usual generic boilerplate reasons such as weak fiscal position blah blah blah (they could say this about every G-8 country). Apparently this took the markets by shock which sent the Euro below 1.35 against the dollar. The reason for this movement in EUR/USD is the anticipation that Moody's and S&P will also issue downgrades. Fitch is usually the first one, which then puts peer pressure on the other two. I am still surprised the ratings agencies have such power after their previous failures in the US housing market.

Right now the EURO looks like an easy short because these fiscal problems in Europe will continue for the next few years. But take a look at the most recent COT report.

You will see that the big speculators are heavily short. It has been at extreme levels for the last few weeks. This is obviously a crowded trade which could precipitate a large short squeeze on any good news out of Europe. Believe or not the idea that Greece could get assistance from the IMF (as has been reported) would actually be good for the Euro. They would be able to successfully externalize the costs to an outside party. The commericals are now long the euro. This sets up a potentially dangerous position where one side is going to be wrong and get taken to the cleaners. This will result in high volatility in the pair. While I do not know which way it is going, I am thinking about going into the FX options market and buying a straddle position to bet on the volatility.

One last thought to consider. The EU leaders love a weak currency and have a strong incentive to make sure the EURO stays low against the dollar. This will benefit their exports (mainly Germany) in world markets. Trichet will help this process along by not raising rates at least through 2010.

Be careful trading.

Black Swan Insights


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