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*Pair trading strategies are only recommended for professional clients who are willing to take risk.
*Trading in financial market carries risk and can result in loss of capital.
*This performance is only observed with historical backtests and not traded by the company.
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A Dwindling EU Forecast
The European Commission, the EU's executive arm, has revised its economic forecast, citing rising inflation, dwindling growth, and mounting geopolitical and natural disruptions to business as the biggest drags on the economy. The European Commission had originally predicted 4% economic growth on the year, it is expected to peg that number at 2.7%. Next year's forecast which was originally pegged at 2.7%, it is now being revised down to 2.3%.
Additionally, Germany is no longer exporting more than what it buys from other countries, highlighting the strains that the nation and other European economies are facing from surging energy and food prices. The country posted a foreign trade deficit of 1 billion euros ($1.03 billion). This marks a significant moment for the German economy, which had reported trade surpluses for several decades. Bloomberg reported that 1991 was the last time the country reported a monthly trade deficit.
A Political Gambit Looms NS1
The first test to Germany’s dependence on Russian gas come in 2 weeks. The Nord Stream 1 (NS1) pipeline, the most important gas link between Russia and the European Union, undergoes annual maintenance from July 11 to July 21. Berlin fears that Moscow will find an excuse to keep it closed for good, cutting gas supplies to Germany completely.
Germany and the rest of Europe are scrambling to fill gas storage in time for winter and reduce their dependence on Russian energy imports. Germany, which has Europe’s biggest economy, has been getting about 35% of its gas to power industry and generate electricity from Russia.
Euro Below Parity – Dollar Charm Kicks In
The dollar's role as the safe-haven go-to currency for investors worried about the economic outlook has been burnished in recent weeks, with the US currency roaring to two-decade highs against multiple currencies. The dollar is up 12% against the euro this year, but it’s also up 13% on the British pound and an astounding 19% against the Japanese yen.
The euro has been particularly vulnerable given the impact of an ongoing spike in natural gas prices on the regional economy and the war in neighbouring Ukraine, and with the European Central Bank behind rivals in raising interest rates. Moreover, business morale is also deteriorating in the euro zone with more worried about a recession. German economic sentiment fell sharply in July to -53.8 points from -28.0 in June.
US Markets not at Russia’s Mercy
The US consumes far more oil than companies extract domestically, requiring it to import some supplies. But it is less reliant on Russia’s oil than Europe and takes only a small portion of its imported crude from Russia. The US gets most of its crude imports from Canada, Mexico, and Saudi Arabia, making it immune to the feud between Russia and Ukraine.
The prices of retail gasoline have been dropping across the nation on account of recession fears. The drop in crude oil prices is also caused by decreased expectations in the energy needs of consumers and businesses as they adjust to high inflation. With commodity prices taking a hit in the past few weeks, consumer sentiments have shifted. As the road map of rate hikes in US is less uncertain in comparison to the EU, it is already being reflected in the US financial markets. Thus, the US bourses are likely to remain relatively buoyed.
Trade Rationale: Long SPX & Short DAX
The chart below portrays a trendline breakout on the ratio between SPX and DAX index. The ratio is likely to move higher given the dynamics in the US and the EU. The relative underperformance of DAX is the key driver for trade rationale to pan out.
DAX Index is priced at $12,761, whereas the SPX index is priced at $3,829 as of July 12th, 2022. The table below elaborates on the dollar neutral investments to be made on both legs of the trade. An exchange rate of 1.004 has been assumed for EUR/USD.
|CMP (LCL Currency)||CMP ($)||Position Size ($)||Units||Margin (%)||Margin ($)|
Date: 13th July 2022
Note: The trade will cease to exist in the absence of the current geopolitical events looming on the EU region.
Risks and Assumptions for Back-tested trading strategies
Data Source: Bloomberg
Data: 14 Juy 2022
Arun Leslie John
Chief Market Analyst
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