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Seeds of Thought

Better Decisions, Better Results

Cognitive Science Meets Investment Management

Issue 15-30
August 16, 2015

What Really Caused the EUR Selloff?

Through the years, I have held numerous corporate titles from VP to MD, as well as more descriptive
labels like trader, portfolio manager and CIO, but in my mind, I am a detective. When significant events
occur in the macro space, the first question I try to answer is, Was it actually a significant event, or
have I been biased either by the positions in my portfolio or my own individual experience? In order to
have satisfactorily answered it in the affirmative, I should be able to explain why its significant.
Like any detective worth his salt, I must
build a case based on the evidence. Just
standing around exchanging theories and
jumping to conclusions based on intuition
with even the most intelligent and
experienced detectives wont do me any
good. I need to build the kind of case that
will hold up in court.
With regard to what happened in China last
week, one look at the chart of fixings since
the peg was removed shows that it clearly
qualifies as a unique event. As for its
significance, well as it relates directly to
policy, only time or a thorough explanation
(highly unlikely), will tell for sure. Rather than play that game though, this edition of Seeds of Thought
is about something only remotely
connected.
Sometimes, during an investigation you
come across an interesting piece of
evidence along the way. Something that
really captures your attention, turning an
open and shut case of suicide into the
investigation of a decade long killing spree
at the hands of a serial killer. For me, the
Chinese Reserves chart (right), which I also
shared earlier this week, falls into that
category.
Somehow, I had completely missed an
!
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Bija Advisors Seeds of Thought

Issue No. 15-30

event far more impactful than even the change in currency policy, and in my mind, it may very well
wind up being what makes this weeks action truly significant. By that I mean it opens the door to a
number of new strategies and creates a new reassessment trigger for just about every position in any
portfolio.

The Epiphany
In discussing the Reserves chart with a client, I suddenly had an epiphany. After years and years of every
expert calling for a dramatic drop in the value of the EUR with very little satisfaction achieved and a
whole lot of frustration experienced, all of a sudden, beginning in April of last year, Success! The
reason? QE of course, right? Perhaps youre right, but I now think QE may have been more coincidental
than causal.
What Im about to explain is yet another way in which China has been far more influential in driving
markets than most are willing to admit, or even fathom. Take a look at the Reserves vs the US Dollar
Index chart showing the 12 month moving average in the monthly change in Chinas reserves (inverted)
overlaid with the US Dollar Index (DXY), using data going back to when China first began the managed
revaluation in 2005. Im not a big believer in my (or anyones) ability to simply eyeball correlations, so I

ran the numbers. Turns out the correlation between the change in Chinas reserves and the USD Index is
roughly 70% on a monthly, quarterly and yearly basis. Its virtually identical when you replace the DXY
Index with EUR/USD, and for good reason.

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Bija Advisors Seeds of Thought

Issue No. 15-30

Almost from the start, the Chinese understood the importance of diversifying the massive reserves they
would accumulate ($4 trillion at its peak). As a matter of process, every time they bought US Dollars
against their own currency, it would automatically trigger a transaction to exchange a portion of those
dollars for Euros. They werent alone though. South Korea, Taiwan, Russia, Brazil and nearly every
other emerging market central bank that stood in the way of their currencys appreciation did the same.
So while there may have existed a wide range of macroeconomic reasons for the Euro to depreciate
versus the dollar over the years, inspiring every hedge fund portfolio manager to fervently short it at one
time or another, inevitably it tended to result in frustration and losses far more often than not.
Functionally, as the pressure on CNY ebbed and flowed, so too did the influence of Chinas central bank
operations on currency markets. The more capital flowed into China and the other emerging markets, the
more EUR resisted the depreciation many market participants were expecting. When the flows slowed,
EUR was more malleable. Then, in April 2014, just as the ECB first mentioned the possibility of
quantitative easing, the Euro finally appeased the bears, beginning its rapid descent. Unbeknownst to
most, while we were all hyper-focused on deciphering every utterance of anyone associated with
European policymaking, something else of perhaps even more consequence had also just occurred. It
turns out, at the very same moment, CNY had begun to come under intense pressure. The rapid growth
in Chinas reserves that had gone on almost uninterrupted for nearly a decade had suddenly reversed.
Considering the correlation between China reserve accumulation and the Euro over the last decade,
combined with the timing of the reversal from accumulation to reduction of reserves that occurred at that
exact moment, it's hard to make the argument that the EUR collapse was strictly a result of QE.
If you buy into my theory, we neednt expend so much effort speculating on why the Chinese changed
tack this week, or what it implies about their own expectations for Chinese growth and its derivative
effect on the psyche of the Federal Reserve. Instead, we simply need to consider whether the downward
pressure on CNY will result in less intervention going forward, both in China and all the other emerging
markets that may take their cue from them. It matters because less intervention would mean less EUR
selling from the central bank community.

Implications and How to Play It

Until now, you could have selected just about any currency to express a bullish dollar view and done
very well. What Im suggesting here is that going forward, you may not be so lucky. Its very possible
that currencies like EUR, CAD, AUD and the others that CBs use to diversify their reserves may not
perform nearly as well (here, "well" means poorly against the U.S. dollar) as they have been. There are a
couple of ways to take advantage of this.
The most obvious is to express the view directly via low yielding, temperate emerging markets against
the dollar. If you believe as I do, that the global slowdown story is playing out in stages, then stage 1
was mostly about the bottom of the supply chain; raw materials and commodities, which is why the
tropical emerging markets were hit so hard. The shift lower in the cost of inputs did wonders for the
trade balances of the temperate emerging markets; primarily those that import raw materials and export
finished goods. Stage 2 may still be in its early days, as faltering global growth begins to show itself
through reduced demand for those finished goods, resulting in exports slumping more in line with
imports for those temperate emerging markets, like China. If that's the case, we may see a dramatic
reversal in the record trade surpluses we've witnessed lately. Of course, that will filter down to the
tropics as well through another round of reduced demand for commodities, so tropical emerging markets
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Reproduction or retransmission in any form, without written permission, is a violation of Federal Statute
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Bija Advisors Seeds of Thought

Issue No. 15-30

may not be out of the woods yet, but going forward, shorting temperate emerging markets may be a
good bet for playing catch up.
Going back to the impact on EUR, an interesting way to express that idea would be via options using the
same EM currencies, but against the EUR, thereby allowing you to take advantage of the lower cross
vols that are the result of the high correlation between EUR and EM until now. Theres also a possible
additional bonus that comes with expressing the view this way. If, as I believe, the US economy begins
showing its own flaws, similar to those seen in just about every other country in the entire world,
thereby altering the expectations for Fed moves and US interest rates going forward, EUR vs EM should
not only keep up with USD vs EM, but perhaps significantly outperform.
I will dig into all of this in future publications and in direct conversations, but for now, allow this to
serve as a seed of thought.

About the Author

For nearly three decades, Stephen Duneier has applied cognitive science to investment and business
management. The result has been 20.3% average annualized returns with near zero correlation to any
major index, the development of a billion dollar hedge fund, the turnaround of numerous institutional
trading businesses and career best returns for experienced portfolio managers who have adopted his
methodologies.
Mr. Duneier teaches Decision Analysis in the College of Engineering at the University of California
Santa Barbara.
Through Bija Advisors' publications and consulting practice, he helps portfolio managers and business
leaders improve performance by applying proven decision-making skills to their own processes.
As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world
for more than 20 years on topics including global macro economic themes, how cognitive science can
improve performance and the keys to living a more deliberate life. Each is delivered via highly
entertaining stories that inevitably lead to further conversation, and ultimately, better results.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America and
Managing Director of Emerging Markets at AIG International. His artwork has been featured in
international publications and on television programs around the world, and is represented by the world
renowned gallery, Sullivan Goss. He received his master's degree in finance and economics from New
York University's Stern School of Business.
Bija Advisors LLC
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Copyright 2015 by Bija Advisors LLC.; BijaAdvisorsLLC.com
Reproduction or retransmission in any form, without written permission, is a violation of Federal Statute
Important disclosures appear at the back of this document