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Tuesday July 27, 2010 - 22:15:23 GMT
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EURO Frustration Builds (FXA)

EURO Frustration Builds


It was not so long ago (try early June) that the euro was trading under 1.19 and it seemed relatively obvious that the slide would persist to at least 1.15 area and more than a few were predicting parity by year end.  Here we are just shy of two months later and the all clear seems to have been sounded for a run at 1.3125 (38% retrace of the November 2009 high to the June 2010 low). 


What changed to radically change the direction of the EUR? 


A weaker US economy comes to mind.  This was surely not in most forecasts in early June and did not become more obvious until labor market data showed problems in hiring.  Housing data supported by the US gvt tax credit into the end of April was showing signs of weakness.  Business investment was not panning out as firms worried about the future (more political business leaders blamed uncertainty in Washington for high cash balances, low business investment and lean labor force, while less political ones blamed weak demand for defensive posture of employers).  It also became clear that banks are not doing much lending to the corporate sector and were holding high levels of reserves with the Fed earning 0.25% rather than lending it out to customers.  Any risk banks were taking was in capital markets (prop trading, asset accumulation) and not in credit creation function of the business.  And many assumed the federal government stimulus was largely exhausted.  State and local governments were no longer receiving the large federal transfers that were put in place in 2009. 


A stronger Euro Zone economy also comes to mind.  European indicators were showing signs of a healthier recovery with exports strong (weaker euro was a clear help), business investment rebounding and consumer sentiment and spending improving.  While Europe’s banks appeared more hobbled by bad loans, still leveraged balance sheets and greater dependence on central bank funding (than US), we only recently have learned that only 7 of 91 banks failed a stress test.  While the stress test looked more like a white wash than fact finding mission to me, to others it was another all clear for buying EUR, risk assets and selling USD, gold and even JPY. 


Okay maybe the market was too one-sided in early June – it was…the 1.1875 to 1.3040 move makes that painfully clear to skeptics like me.  However, in its propensity to cross the deck of the ship and not stop mid-ship, the market is now at risk of losing sight of risks to the EUR, risk assets and growth.  The very real strains in the banking system in the spring were not unfounded and no white washing of balance sheets in the latest stress test can fix what is broken.  Ongoing reluctance of banks to lend to each other (albeit less than May) and a still heavy dependence on the ECB for funding and parking toxic assets is not constructive for growth.  Deleveraging, loan loss providing and capital raising efforts are all still ahead of Europe’s banks, not behind them as is the case in the US.  And I liked the outlook for exports much more at 1.19 than 1.30.  Sovereign debt risk also remains a risk despite the establishment (since May) of the near $1trln stabilization fund.  The modest bond purchases of the ECB and reluctance to embrace QE is also a problem ahead for growth and the smooth functioning of capital markets.   


And more recently the BRICs appear to be slowing in the face of tighter monetary policy…Russia is the lone exception here but rate cuts have stopped.  I also wonder how the world’s exports grow when the main importer (the US) is simply not spending.  Selling into BRICs is a good alternative to selling into USA, but for how much longer if BRICs are selling a lot less into the USA


Decoupling supposition is about as difficult to kill as Ponzi schemes and supply side economics…all proof of the greater fool theory.


Surely I am not alone in remaining skeptical of the euro’s gains and see the 1.3125 level ahead as key for euro upside continuing.  The market will need to break above it and decisively and soon, otherwise this rally is toast.  I am inclined to try again at selling this market short for a move to 1.25 in the next few weeks.  Perhaps Friday’s US Q2 GDP report will be a reminder that the US economy ran into problems in May and June but did not die.  At over 1.30, the euro is priced for a US funeral.


David Gilmore




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