The Euro and the Dollar
I’d like to do a short-technical piece today to discuss the euro and the dollar. Before I go into the technical picture, let’s first summarize the fundamental backdrop. Now, the U.S. equity markets rose heading into the EU summit and launched soon after the details were given on the Friday morning of June 29th, which were:
- Single Pan-European bank regulator by year-end ‘12
- Once the supervisory mechanism was in place, the ESM could capitalize banks directly
- Ireland to get better bailout terms
- Spain to get aid from the EFSF until the ESM is up and running, without gaining seniority status on the debt
- ECB to act as agent for the bailout funds
- €120B growth pact
Since then, concerns have shifted to a weak Eurozone and the effect it will have on U.S. multinational companies. We had more negative preannouncements heading into this quarter than in the last earnings season and that has investors on edge. At the same time, we know that central banks are leaning hard in the accommodation direction. ISI Research counted 65 policy eases in the month of June, globally; in addition, we started July off with a quarter point cut in the ECB’s rate to 0.75%, England restarted QE with a £50B injection, and the People’s Bank of China cut rates a second time in the last month. As a bear, it’s a lot riskier shorting the market while central banks are easing. Central bank surprises are to the upside. Our own Federal Reserve Bank has extended Operation Twist, but that’s it. Investors are wondering what kind of jobs number or manufacturing number is it going to take to trigger QE 3. We’re already near similar price statistics the Fed used to initiate QE 2 in 2010. Look where oil is, look where the CPI is, and look where the CRB commodity index is as I mentioned last week.
This week, the euro was breaking down technically on worries whether the euro will be around tomorrow as a viable currency. Last year, it was “the dollar is going to collapse.” Now it’s “the euro’s going to collapse.” Nobody knows for certain. The EU and Germany have made it clear they’re going to do everything in their power to make sure the euro gets defended. We’ll just have to see. One thing is clear, the Euro is approaching an extreme support zone while the U.S. dollar is currently dealing with a resistance zone of some importance but not extremely important like 88 on the dollar index. Technicians deal in probabilities. It’s more probable price will reverse. Breaks in these levels have a low probability, but if the levels are broken, the game changes.
That chart should look familiar to those who follow my work. Last year, the chart in the U.S. dollar looked the exact same. Technicians were pounding the table on the coming collapse in the dollar when a multi-year triangle broke down in April 2011. The problem: the dollar was entering an extreme demand zone (support). Here’s the chart from last year:
I still have the chart saved under my Stockcharts file. The dollar consolidated for another few months near 74 and then began an uptrend in September last year. If the dollar breaks above 83.50 by 1-3%, the next resistance zone is near the 2010 highs near 88.
Since the EU summit, there has been doubt about how much support the current bailout funds (ESM/EFSF) can offer to sovereign bonds. The market liked the idea of unlimited resources with the ECB’s SMP facility buying sovereign bonds directly. They really loved the idea of the Long-term Refinancing Operations which indirectly supported sovereign bonds by supplying two huge cash infusions in December and February of this year, at 1.0% for three years to the banks.
The second issue is that the economy continues to worsen. We’ve seen the manufacturing data. It’s been contracting for a few months now. Last week, the Eurozone’s manufacturing numbers were better than expected, but they were still contracting. And so, slow growth concerns loom and now those are hitting analysts here in the U.S. Analysts are looking at multinationals with currency liabilities. A rising U.S. dollar does not help our exports. Companies like Caterpillar (CAT) and McDonalds (MCD) had huge profits from currency translations a year ago due to a sinking dollar. That’s not the case anymore and those charts are suffering.
Another reason we’re seeing a weak euro is due to “good” reasons. The ECB dropped rates last week while the Fed’s non-standard policy is at a neutral stance. They extended twist last month, but nobody expected them to shut it down. The Fed Minutes came and went without hinting at any change in non-standard policy tools. Granted the minutes were from the Fed’s meeting a month ago before the latest jobs or manufacturing numbers, but still, the policy differentials between the ECB and the Fed have spread wider. This is a catalyst for a falling euro. The euro falling on policy differences is a lot better reason than fear of a EU member leaving. It’s a good reason, because eventually, cheap euros make European products cheaper and strengthen exports, economics 101. Eventually, more demand for cheap European exports will stimulate manufacturing and tourism, but that takes time.
On that note, we got some trade flow data for Germany this week. Exports and imports declined in April, -1.7% m/m and -4.9% m/m, respectively. May’s report showed a rebound with exports up 3.9% m/m and imports surged 6.3% m/m. Trade flow can be volatile, but the last three months compared to the same three months last year have shown a 10% annualized pace following the declines of 2011. That’s great for Germany; however, we need to see the same recovery in other parts of Europe. If they are all using the same currency, again, we should expect to see stimulus here in activity due to a cheap euro.
If the Federal Reserve finally moves towards quantitative easing, in which some of the governors want according to the minutes, then we could finally see the policy differential spread between the two central banks narrow. The main question on every investor’s mind is, how much more growth deceleration and price contraction does the Fed want to see before enacting QE3?
I can’t answer that. The market doesn’t seem to know. Late summer 2010, it was very clear after Bullard’s piece and Jackson Hole that the Fed was on the path to QE2. It’s not as evident to me right now that QE3 is in the bag. That’s why gold is flirting with its lows. Equities have reversed their short-term downtrend, within an intermediate-term uptrend, within a long-term downtrend (from April highs). That’s right...clear as mud. From that technician-speak, you can take away that the market is in a very neutral position with most indicies flirting around the 50-day moving average while long-term moving averages are still climbing. Volume is light and the market hasn’t set a clear sense of direction. The S&P 500 is locked in a narrow range with 1363 as resistance and the rising uptrend from the June low. If the rising trend breaks, I believe the downtrend will resume, but until then I have a neutral stance towards equities. Healthcare, staples, utilities, homebuilders, and biotechnology stocks continue to show strong charts and these are areas I’m most comfortable with right now.
The euro and the dollar are both near significant technical levels that should give trend followers pause. The recent manufacturing data in Europe was better than expected. Eventually, a cheap euro will help Eurozone exports just like a cheap dollar helped Caterpillar and McDonalds last year. Despite the steps in the right direction as EU leaders finally allow capital directly to banks instead of through sovereigns (enlarging debt), they sorely lack a fiscal plan to stimulate growth. The €120B marked in the growth pact looks like a lot of smoke. Because economic conditions are not improving, credit agencies will continue to lower ratings, increasing refinancing costs. There is a shift to move away from austerity towards growth, but it seems it’s still in its infancy. That means that the real catalyst for changes in currency trends between the euro and the U.S. dollar will have to come from central bank policy now that the EU summit is behind us. Investors and traders should keep their eyes focused on the Fed going into their early August meeting and again at Jackson Hole.
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