The big three-to-six month trends in the euro have been fairly easy to follow since the 2008 credit crisis. I am going to recap just how easy it was to give you an idea of how we can continue doing it in the future. Once we understand the dynamics of currency movement over longer time frames, we can make high-probability guesstimates about the next trend.
As the S&P 500 continued to crater to new lows in early March of 2009, I wrote the technical analysis view on the single currency for the April edition of Futures Magazine. In that report, I highlighted the directional breakout points, citing support at $1.24 as a critical pivot where the bears would pile on if given the chance again.
Helicopter Ben
And on the upside, I said you had to stop-out of any short positions and be long the euro above $1.31. As the S&P fought for a bottom just below the 700 level, I did two critical video reports from the trading floors of the CME, one on March 10th where I said to "buy the S&P at 690, looking for 740 within the week" and another on March 16th where I said to "be ready to buy the euro" as it approached $1.31.
Two days later on March 18, "Helicopter Ben" Bernanke gave us the certainty about quantitative easing programs that markets were looking for. And he commenced a carpet-bombing of the world with US dollars. The euro shot up nearly 5 cents (500 pips) in one day on that brand of Uncle Sam monetary certainty.
Risk Appetite and Correlations
Why would the euro launch so much on this event? A lot of it is easy to figure out in hindsight. But I wasn't using hindsight then. I wasn't even really speculating on market reaction to monetary policy, although that's what the big banks were certainly doing. I was just watching the US equity market and the technical level that I had pegged in the euro as a make or break for strength.
It really all came down to the strong positive correlation that the euro had exhibited with the S&P 500 for years prior, and that would continue, with some hiccups, right until today. In early 2009, that correlation was as high as +0.5 for any 3-month period and as high as +0.8 in some 3-week periods.
Many prognosticators today talk about the weak dollar moving equities and commodities. While there is some truth to this, I think it is a big misconception to portray the dollar primarily as the tail wagging the dog of US equities. Yes, the currency markets dwarf the equity markets in daily notional turnover volume.
Weak Follower
But a lot of that is mere speculation and "swaps" and capital flows, whereas equity markets are about forward-looking investment protocols where fund managers must take a view on the economy and relative rates of return. In other words, bull and bear markets still come back to ideas and projections about corporate earnings within the economic cycle. And that's where big asset allocation decisions are made that move currencies with biggest impact over the long run.
On top of this, the euro was simply what I called at the time a "weak follower" of risk appetite. While the Australian dollar rallied early and strongly on its relatively high interest rates (i.e., the FX carry trade) and strong economic fundamentals from Chinese demand for commodities, the euro went along for the ride on cheap dollars and the recovery in equities.
How Does the Chart Tell You What the Titans Will Do?
My technical method for finding big trends in FX (I traded it professionally for 9 years as a market maker on a high-frequency spot-futures arbitrage desk), is as simple as it gets. I use the 10 and 20-week moving averages to gauge trend. These are roughly equivalent to the 50 and 100-day moving averages. Their direction and agreement are a terrific and easy-to-use guide post for FX trends because they tell you where the big banks and hedge funds, the "titans" of the interbank market, are already moving things.
And I rely on them because I'm not smart enough to track and analyze all the fundamentals that are involved in cross-border exchange. From GDP and trade to inflation and interest rates, who can decipher all the variables and interactions of two countries and their currencies? Even the economists can't with any regularity. Put a half-dozen in a room and I swear you'll get 12 predictions, as one hand defers to the other.
Price Precedes Fundamentals
So I've always said that "price precedes fundamentals" for the simple reason that the big money in FX starts to move price in a given trend long before the economists have it figured out with perfect hindsight. Which isn't to say I ignore FX fundamentals either. I actually enjoy learning about them and trying to figure them out. It's just that they can be very complicated and hard to figure out, whereas price is easy to follow once a new trend is in motion.
Need proof? Based on any analysis of the brewing crisis with the European "PIIGS" in 2009, any rational person would have thought to sell the euro at $1.31, not buy it. But sometimes it seems as if the currency markets have a mind and reasoning of their own. When in doubt, I simply follow the path laid out by the titans. Their economists are usually among the best in the world and they aren't messing around with so much money on the line and little vested interests (ala equity fund managers) other than pure profit motives.
Grecian Cracks, December 2009
The day after Thanksgiving in November of 2009, I did the early morning shot for CNBC from the floor of the CME. Getting up at 2:30 am to do the 4:30 hit for their WorldWide Exchange program with anchors in Asia and Europe isn't always fun, but it was that day because we just had the news over the holiday about Dubai's unfolding debt crisis. I called it "the first real test for the market recovery since the credit crisis abyss."
A couple of weeks later, the Greek debt tragedy hit the front pages. I appeared on CNBC’s "Power Lunch" on December 16th and said "sell the euro at $1.46" as I saw a top had formed. The rally from $1.31 to $1.51 was over and this was visible in the 10 and 20-week moving averages getting ready to cross. I also pointed out that the Europeans had no more interest in a strong euro above $1.50 than the Chinese did in a freely floating renminbi.
Sell It, and Sell It Again!
As the news heated up about the depth of the European debt crisis, the chart was clear, even if the fate of the euro wasn't. In February 2010, I was on CNBC again and said to sell the euro at $1.38. And again in April, when news of a Greek bailout seemed imminent, I said "sell the news" of any such repair. The euro was already down to $1.33 and an interviewer challenged me that "it's already lower!" as if I was chiming in late. I said, "Yes, and it's going lower." Never doubt the powerful momentum of a freight train trend driven by smart money, top-tier banks.
The euro, of course, was on a path to test the 2008-09 bottom around $1.25. And as we learned of the extent to which French banks owned Greek debt, I started comparing the euro crisis to the US banking debacle. In essence, what appeared to be a sovereign debt crisis between national banks would quickly become a systemic banking crisis similar to our own because of the exposure of European commercial banks.
"Death of the Euro" Brings Capitulation Bottom
As US equities searched for support following the spring swoon — thanks to Deepwater Horizon, the "flash crash," and other "sell in May" feelings — the euro became dramatically oversold below $1.20 in June of 2010. What was hysterically funny to me at the time was the number of commentators suddenly calling for the collapse of the common currency.
I don't claim to have or use a crystal ball, so I try not to make bold predictions like that. To me, the odds favored things staying somewhat the same with a few "adjustments." The Europeans had too much invested both financially and psychologically in the euro experiment to let it fail.
So I said, "The euro won't fail, but it may go to parity for it to survive." Instead, the euro found a bottom last summer and, for a short while, became a leader of risk appetite by preceding the S&P bottom in August and rallying all the way back to $1.33. The long-term moving averages lined up for continued strength and I advised readers of my currency column at TradersReserve to buy the September dip to $1.27. By November, the euro reached for $1.43.
Euro Disconnect and Breakdown
Then things got really interesting. The common currency went straight down for 4 weeks that month, finally puncturing $1.30 and then bouncing hard back up to $1.34. And this while the S&P only stalled a little and drifted from 1,225 to 1,175. So in a way, the strong correlation got a little disconnected from June through December, with the euro going opposite from US equities in any given month.
Over a seven month period, including their summer lows, the overall positive correlation persisted from June 1 to December 31. But the S&P advance of 26% during that window, versus the 12% climb in the euro seemed to indicate another stall in risk appetite might be around the corner.
January T-Rex Rally on Rate Expectations
Indeed, I was trading that expected decline the first week of the new year as the euro collapsed from $1.34 to $1.29, taking out the key November swing lows at $1.2970. I thought, "That's it — the euro is toast now!"
But something funny happened on the way to a collapse to parity. The euro stopped going down below $1.29 and staged monstrous rally the first week of January that took it back above $1.34. On the weekly chart, it evolved into what technicians would call a big, fat reversal candle.
What caused this monster reversal, other than a milder 4-week push by the S&P 500 above 1,300? I didn't know it until into the 3rd week of January, but 2-year yield spreads between the US and Germany had greatly widened in the first week of January to nearly 2%. And when all else is mildly uncertain, or of little catalyst in FX, the carry trade rules.
Besides the fact that widening yield spreads can be indicative of future robust economic activity, there is simply the advantage of earning more interest in higher yielding currencies. And despite the fact that currency carry is not without risks because adverse exchange rate moves can dwarf interest earnings, FX carry trades can have a self-fulfilling momentum when hot money flows into them and drives price favorably in the higher-yielder's direction. In other words, if you trade FX for a living, you have to be on board these trains or you don't survive.
Big banks have their fingers on these currency interest rate differentials every day, and once 2010 was in the bag and books were square, the euro accumulation began in a frenzy that did not stop until May and $1.49 was breached. Of course, it didn't hurt that the S&P was in a steady rally mode either despite the horrible quake in Japan. And, I'm sure by now, it is not lost on you that both topped out the first week of May.
What Have We Learned from the Past?
I spent the last ten minutes of your life recapping this trading and economic history for one reason: to ingrain the dynamics of FX price movement in your brain. It's one thing to talk about asset correlations and carry trades — two major drivers of FX price movement — and another to show how they have worked and continue to function, whether or not we agree with them.
Real examples teach best. And if you believe that maybe I have merely told a clever story in hindsight, you can go back and look at the price charts and see for yourself. Or look up my appearances on CNBC where I made the calls in real time as the stuff was happening.
In any case, here's my summary of the signposts to watch now:
Right now, the euro is consolidating in the middle of a significant long-term trading range between $1.20 and $1.60 and the tug-of-war tension is between the US dollar printing press on one side and the structural debt crisis of the European monetary union on the other. As I've said for two years, it's really a fundamental battle of whose debt problem matters more between the largest producing economies on the planet.
On the chart, the 10 and 20-week moving averages are still pointing bullish, but looking like they could be ready to roll over. And the big picture is one of lower highs from the monthly view… $1.60, $1.5140, $1.4940 over the past three years.
Regarding interest rate differentials, as hawkish as the ECB is lately with their single mandate and vociferous fear of inflation, yield spreads are stable and not widening at about 1% on the shortest end of central bank rates and about 1.25% for 2-year government debt. The Europeans walk a thinner tight rope than us as they try to keep rates down to work out of the debt crisis while not letting inflation catch fire. In this way, the carry trade has less potential in it going forward, as much of the juice has been quickly squeezed out.
So which way will the battle resolve? I think the euro is in a longer-term topping process and that the odds favor seeing $1.30 this year before we see $1.50. The euro and the monetary union will survive I believe, with some possible adjustments that we can't yet know. Sure, smarter minds than mine have ideas about it, but it's such a field of unknown unknowns that I say "just watch the market — it will tell you what’s going on."
Right now, the currency market is saying "We're not sure, but a semi-crippled Europe looks as good, if not better, than a spendthrift US."
It's All Relative
What does all this mean for equity investors? A weaker currency is certainly good for exporters on both side of the pond, whether you are Caterpillar (CAT) or Siemens (SI). Do we care that export gains are achieved through competitive or stealth devaluations of home currencies? Maybe we do. But it's all relative in a global economy of fiat currencies, where the big ones aren't going to collapse, contrary to the doomsayers with their wild, shocking predictions.
And you have to consider that from crisis, often comes a new equilibrium. When you accept that Europe has its own unique problems, just like the US and its burgeoning municipal debt crisis, it's hard to say how things will resolve. Who predicted the near collapse of the US financial system? And who predicted its amazing recovery from the abyss? Not many.
As Moody’s Investor Service warned last week, three of France's top banks could be in for a credit downgrade as they continue to use cheap US dollar funding to roll their large exposure to Greek debt. BNP Paribas, Crédit Agricole and Société Générale may all be playing hot potato with debt of a deteriorating quality, borrowing over $75 billion on the short end to finance their longer-term holdings of Greece government paper.
China Loves Euros Too
There are unique dynamics between powerhouses Germany and France that probably find a new balance here too as they turn their attention to sorting out what to do with the common thorn-in-their-sides of Mediterranean debtor nations. And one thing is for sure as Germany surges its volume of exports to China: a cheaper euro is a better euro.
According to an April 6 story on Bloomberg.com by Jeff Black, "With its consumers and companies sating their appetite for power turbines, cars and electronics, China became Germany's largest non-European customer at the end of last year, helping drive up share prices from BASF SE to Bayerische Motoren Werke AG."
That was a point I left out of the story of the monster euro reversal rally from January. China was reported to not only be a major buyer of the new euro bonds being issued to finance the PIIGS crisis, but they were vocal enough in support of the euro currency as to be suspected buyers of it in the spot market.
Still think the euro is going away anytime soon? I’m gonna go with a big, fat "Think again." Especially when I read a quote like this one from the Bloomberg story that decries the sense of massive structural changes necessary in anyone's fantasy of going backwards to the German deutschemark:
"The theme for this decade is that millions of people in China want to live like Europeans," said Herbert Perus, head of equities at Raiffeisen Capital Management in Vienna, who helps oversee about $36 billion. "The 'Made in Germany' brand is going to be very strong in this market."
When you look at this way, and visualize all the assets and investement machinery built and priced in euros now, it's probably not a stretch to think they will find a way through this debt crisis and emerge stronger five to ten years from now. At least that's what the market is telling us now.
Kevin Cook is a Senior Stock Strategist for Zacks.com
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