Morgan Stanley: Shorting EUR/USD remains a good choice as the US Dollar Index surges

On April 15, 2024, Morgan Stanley released its latest research report stating, the opportunity to short the Euro/US Dollar has arrived!

Morgan Stanley believes that at the beginning of 2024, we are in a market environment characterized by high real interest rates, strong risk appetite, and low foreign exchange volatility, making it very suitable for arbitrage trading. Morgan Stanley refers to this market environment as "Regime 2".

However, with sustained high inflation data and increasing geopolitical risks, the market may transition to "Regime 3". This market environment is more favorable for the US Dollar.

The Euro, Swiss Franc, and Japanese Yen tend to depreciate against the US Dollar in both of these environments, but the Euro has the lowest relative implied volatility, the least short interest, and the highest likelihood of central bank policy divergence, making it the preferred choice for investors.

While shorting the Euro/US Dollar position through options can be profitable in both "Regime 2" and "Regime 3", in "Regime 3", the increased geopolitical risks and the potential divergence in monetary policies between the Federal Reserve and the European Central Bank amplify the risk/reward ratio of this trade.

"Regime 2": Paradise for Arbitrage Trading

Morgan Stanley believes that at the beginning of 2024, we are in a market environment known as "Regime 2". This market environment is characterized by high real interest rates, strong risk appetite, and low foreign exchange volatility, making it very suitable for arbitrage trading:

• Higher Real Interest Rates: In "Regime 2", real interest rates (interest rates adjusted for inflation) are typically high, making arbitrage trading where one borrows low-interest rate currencies and invests in high-interest rate currencies more attractive. During this time, there is generally optimism about economic growth and commodity prices, driving investors towards risk assets.
• Higher Risk Appetite: In this environment, investors have an increased risk appetite, seeking higher risks and returns, and directing capital towards investment opportunities that offer higher returns, such as emerging markets or high-yield bonds. They are more likely to engage in cross-border arbitrage trading.
• Low Foreign Exchange Volatility: Low volatility reduces the risk of exchange rate fluctuations when holding foreign currency assets. This is particularly important for arbitrage trading, as profits from arbitrage trades may be eroded by exchange rate fluctuations. Low volatility provides a more stable environment, allowing investors to benefit more reliably from interest rate differentials.

Therefore, due to the combination of the above conditions, arbitrage trading has become very popular. Investors borrow low-cost currencies (such as the Japanese Yen or Euro), and then invest these funds in currencies that offer higher returns (such as the Australian Dollar or emerging market currencies). The prevalence of this strategy has led to a significant increase in investor positions in certain currency pairs. This means that often, investors' returns do not solely come from the performance of the assets they invest in, but from the arbitrage opportunities themselves.

However, Morgan Stanley points out that the recent market environment seems to be changing, primarily triggered by the following factors:

• Persistent High Inflation: Recently, the US CPI has exceeded expectations for three consecutive months. High inflation makes the path to rate cuts distant, potentially forcing the Federal Reserve to "stay put" or even raise rates, increasing borrowing costs and affecting the attractiveness of arbitrage trading
• Increased Geopolitical Concerns: The uncertainty in geopolitics has increased market risk aversion sentiment. For example, conflicts like Russia-Ukraine or escalating tensions in the Middle East could lead investors to withdraw from emerging markets or higher-risk assets and seek safe havens.
• Changing Views on US Economic Growth and Commodity Prices: The previously benign strong US economic growth and rising commodity prices may be reassessed as detrimental factors in the context of sustained high inflation. This is because robust economic growth could further exacerbate inflationary pressures, forcing policymakers to take restrictive measures.

Morgan Stanley stated that due to the above changes, "Regime 2" may end earlier than expected, and "Regime 3" could become the next possible market environment.

"Regime 3" Potential for USD Appreciation and EUR Depreciation

Morgan Stanley points out that the transition from "Regime 2" to "Regime 3" signifies a shift in the market from a stable, high risk appetite environment to a more turbulent, risk-averse state. Regime 3 may exhibit the following characteristics:

• Higher Market Volatility: Due to policy changes and geopolitical uncertainties, the market may experience greater price fluctuations.
• Increased Risk Aversion: Investors may avoid higher-risk assets and instead invest in safer assets such as gold or the US dollar.
• Monetary Policy Divergence: Different countries and regions may adopt different policy responses, leading to increased divergence in monetary policies that can affect currency exchange rates and international capital flows.
• High Real Interest Rates: Central banks may delay interest rate cuts to combat inflation, making holding USD assets more attractive.

"Regime 3" is a market environment relatively favorable to the USD, where currencies that previously benefited from "high risk appetite" and "low-yield currencies" in "Regime 2" may face pressure.

Firstly, currencies that benefited from high risk appetite and arbitrage opportunities in "Regime 2," such as emerging market currencies or high-yield currencies, may experience dramatic reversals in Regime 3. This is because:

• Capital Withdrawal from Risk Assets: With reduced risk appetite, funds may flow out of these currencies considered higher risk, leading to depreciation.
• Increased Safe Haven Demand: Against the backdrop of global economic or political uncertainty, investors may seek safe-haven currencies, especially the USD, making these higher-risk currencies relatively weaker against the USD.

Secondly, low-yield currencies, typically referring to currencies of countries with low interest rates and slow economic growth (such as the Euro, Swiss Franc, and Japanese Yen), usually perform poorly in both "Regime 2" and "Regime 3," mainly because:

• In "Regime 2": Low-yield currencies, due to their inability to provide attractive returns, are often used as a source of funds (i.e., borrowed) for arbitrage trading
• In "System 3": Although these currencies may be considered relatively safe in other environments due to low risk, they may still underperform in a market driven by a strong US dollar and risk aversion, as investors seek more certain safe-haven assets such as the dollar.
• Economic and Policy Differences: Economic growth and monetary policies in the Eurozone, Switzerland, and Japan may significantly differ from those in the United States, especially in dealing with inflation and economic slowdown.

Among them, low-yield currencies tend to depreciate against the dollar in both of these environments, but the euro may face greater depreciation pressure in situations where it has the lowest relative implied volatility, the least short interest, and the greatest central bank policy divergence:

• Low Relative Implied Volatility: The euro has lower implied volatility relative to other currencies. Lower implied volatility means that euro-dollar options are relatively cheaper, providing investors with a cost-effective entry point to short the euro through options.
• Less Short Interest: Currently, there is less short interest in the euro compared to other currencies. Market pessimism towards the euro may not be as strong as towards other currencies, potentially providing more downside room for the euro as changes in market sentiment could lead to more short selling.
• Greater Potential for Central Bank Policy Divergence: The divergence in monetary policy between the European Central Bank and the Federal Reserve may be more pronounced. Especially in dealing with inflation pressures and economic growth slowdown, the policy responses of the two may differ significantly. If the Federal Reserve leans towards hiking rates to curb inflation while the European Central Bank delays rate hikes or adopts a more moderate policy to support economic growth, this would further depreciate the euro against the dollar.

Based on the above factors, Morgan Stanley believes that shorting the euro/dollar position through options is profitable in both "System 2" and "System 3". The increasing geopolitical risks and the potential divergence in monetary policies between the Federal Reserve and the European Central Bank make the return on this trade higher.