Most market players believe growth is on track in Europe and the European Central Bank (ECB) has everything under control. I believe the reality is quite different. And once the market wakes to this reality, the euro could fall fast and far.
Let's take a look at three facts.
1) Credit problems in the Eurozone are real and severe. The European Central Bank (ECB) is pumping just as hard as our Fed—even harder on some measures. According to Grant's Interest Rate Observer [our emphasis]:
All the Fed moves, "have, in aggregate, grown the Federal Reserve Bank credit by only 2.2% annualized, or $18.7 billion," according to Grant's. "The Fed has been aggressively selling down its Treasury portfolio so the net impact of the TAF (term auction facility) has been muted in terms of balance sheet growth."
But, the seemingly cautious and credible reserve manager across the pond, known as the tough-talking and tough-acting European Central Bank, has been anything but conservative in controlling its balance sheet. According to Grant's: "The ECB, which talks a hawkish game, has in fact been more generous than the Fed in providing liquidity. Since the beginning of August, the ECB's balance sheet has ballooned by €172 billion ($267 billion), and annualized six-month balance sheet growth is running at 22.3%."
I find it interesting the US Fed is always perceived as being so reckless compared to the ECB. Yet the ECB is pumping with both hands too. In fact, over the past few days, the ECB was back in flooding the market with euros. This excerpt from a Bloomberg news story yesterday tells me there are real strains in the euro credit market [our emphasis]:
"Amid resurgent money-market strains, the European Central Bank pumped an extra €35 billion ($55.3 billion) into the European banking system as part of its regular market operations.
"The ECB said it allocated €150 billion in its main seven-day repurchase agreement, €35 billion more than it estimated banks require for routine weekly business. Separately, the Swiss National Bank offered funds via a one-week repurchase tender at 2%, following its decision Monday to try to bring money-market rates down by lowering the rate at which it auctions funds.
"The extra central-bank funds don't appear to be easing banks' worries about lending to one another for longer periods of time. Most longer-term reference rates for unsecured euro-zone lending were higher Tuesday, with the three-month Euribor edging up to 4.731% from 4.727%."
So, the more we pull back the covers, the better we can understand why the ECB is pumping and dumping. Growth is fading fast, and there are big problems on the horizon.
2) House prices are tumbling in two key markets—Ireland and Spain. If you follow only US financial journalism you would think the US is the only place on earth with a housing problem. But the fact is, that housing prices in both Ireland and Spain have appreciated a lot more that those in the US over the past 10-years. The pending fall in Ireland has been described as a crash in the making. Spain's crisis could soon be labeled a disaster in the making.
"The Irish economy is heading into recession," says Alan Ahearne, an economist at the National University of Ireland, and a former senior economist at the US Federal Reserve.
Average home prices in Ireland soared 300% over the past 10 years. But over the past six months, home prices and residential construction have fallen sharply. Another problem facing Ireland's corporate sector is the "overvaluation" of the euro. Many of Irish jobs are created by foreign multinational firms with plants in the country to take advantage of Ireland's skilled workforce. But now, this once-powerful source of new jobs is cutting jobs fast as exports from Ireland, thanks to a soaring euro have become uncompetitive. This is hammering Irish jobs.
Irish unemployment jumped to 5.2% in February, compared to just 4.5% a year ago. Once considered a European tiger country because of its soaring growth, Ireland is about to become a major drag on the Eurozone.
Nobody Expects a Spanish Housing Recession!
And then there's Spain. Spanish home prices jumped 130% between 2000 and 2006, making the US increase pale in comparison. According to Standard & Poor's, there was a 27% decline in Spanish home sales in January 2007 from 12-months prior, while permits for residential housing tumbled 41% in the 12-months to September 2007. Spain's real estate may deteriorate swiftly as early as this quarter because housing permits are key when forecasting future housing starts and construction spending.
The country's competitiveness is hollowing out, which makes the housing bust that much more dangerous for future growth prospects. This is an excerpt from a March 7, 2008 article that appeared in The New York Sun:
"The seriousness of Spain's coming housing bust is underlined by how large that sector looms in the Spanish economy. America's house construction industry and housing related industries constitute less than 10% of the economy, whereas in Spain that figure approaches about 20%. Equally troubling is Spain's loss of international competitiveness over the past few years — around 35%, which is now reflected in an external current account deficit of about 9% of GDP. This makes it highly improbable that jobs lost in the construction sector will be offset by job gains of any meaningful extent in the rest of the economy."
2) Fiscal sickness is in the zone. One of the main benefits for a country to join the Eurozone and link itself to the European Monetary System is the huge financial advantage it provides. For example, even though the world knows both Greece and Italy are fiscal basket cases, both countries have been able to issue new bonds to fund government spending that are in line with market interest rate in line with Germany. This is a system that makes no sense.
The inherent difference in the risk of default in Greece and Italy versus Germany is huge. The European Monetary System masks this reality. But now, for the first time, we are seeing the interest rate spread on Greek and Italian bond yields relative to Germany widen substantially. This is a reflection of real risk in the system starting to be priced in.
There is a growing and real risk this trend will continue and expose the soft underbelly of the European Monetary System for what it really is—a patchwork of mollifying economic and political platitudes to form a more perfect union. We think these growing strains are one of the major reasons why the ECB is expanding its balance sheet so far and so fast.
Credit problems, housing problems, and fiscal problems we believe will continue to weigh on the euro. And it's not that these same problems don't also exist in the US, they most certainly do. But the difference is, traders already know most of the bad news about Uncle Sam, while the euro is still priced as the darling child.
And when we examine the relative technical position of the euro versus the US dollar, the euro looks overextending and the buck due for a bounce...
The Technical Stuff Looks Euro Bearish—Dollar Bullish
Let's first take a look at the euro daily chart.
1) The euro recently failed to make a new high against the dollar on some very decent growth news emanating from German last week, which was highlighted far and wide by our financial press. This represents poor price action relative to the news, a big negative on our qualitative sentiment indicator. But it did lead to a major head fake as indicated on the chart.
2) The Relative Strength Index turned negative (blue line at the bottom of the chart).
3) To gain some perspective on just how far the euro is extended, notice the red line on the chart—the 200-day moving average. It is all the back at 14405!
4) The a-b-c letters labeling the chart (red) represent a stylized corrective pattern that we expect will play out based on our fundamental and technical view.
EURUSD Daily:
http://www.sovereignsociety.com/~web...308_image1.gif
And there is another interesting connection that may not bode well for the euro — it's correlation with commodities. Though we are seeing a bounce in commodities today, commodities appear due for a real correction and I think it would be another factor that may drag the euro lower.Commodities have been playing the role of alternative hiding place out of the dollar. And of course the euro is the key dollar alternative currency. So it's not surprising to see the pair move so tightly together.
EURUSD vs. Commodities Index Weekly:
http://www.sovereignsociety.com/~web...308_image2.gif
The pair has diverged a bit lately. Commodities have pulled back, while the euro has staged a relative minor correction from its recent high. We believe there is plenty of scope for commodities to take a much needed correction. And if we are right, the euro should closely follow and close up the divergence we have labeled in the chart above.Now, let's compare the technical position of the euro to the US dollar index chart below. The buck appears oversold and due for a bounce higher.
As you look at the chart below, I want you to focus on these highlights:
2) Trading an amazing 6 full points below its 50-week moving average
3) A divergence in the price oscillators, highlighted at the bottom of the chart. I.E. the dollar index made an all-time new low, but the Relative Strength Index (RSI) failed to confirm. That usually by itself is a pre-cursor to a sharp bounce higher.
http://www.sovereignsociety.com/~web...308_image3.gif
As you can see, I have both fundamental and technical reasons why we believe the euro is due for a major correction lower against the US dollar. I have a multi-week target of around 1.4800 on the euro against the dollar. If it gets there, your euro puts will soar.So hopefully you will be able to be filled on my order to buy June euro puts (EDB RR) that I recommended this morning in Issue #130. I expect it to be a big winner!
Best wishes,
Jack