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The Euro: From Whatever it Takes to Whatever it Must

The Euro: From Whatever it Takes to Whatever it Must

2015-11-20 15:04:00
James Stanley, Strategist
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Talking Points:

- The European Central Bank has a pivotal meeting on December 3rd, where many are expecting the bank to increase or extend their QE-program.

- This is the most recent salvo from the ECB in an attempt to solve a major fiscal issue throughout the European economy.

- Most evidence points to additional action out of the ECB in two weeks, and we received the latest reminder of this with Mr. Draghi’s comments this morning that the bank will ‘do whatever it must.’

While much of the world looks to the Federal Reserve for that first rate hike in over nine years, across the Atlantic, Central Bankers are dealing with far different concerns.

After the European Debt Crisis engulfed the economy, the viability of the single currency and, along with it, the European Union as a whole came into question. After all, without a banking union tying the countries within Europe together, what use was sharing a single currency? National Central Banks within Europe essentially lose much-needed flexibility to handle economic off-sets. Before 1999, if Greece was having problems they could simply weaken the Drachma. The weaker Drachma would draw trade flows (given price advantages of a more valuable Dollar, Yen or Deutschmark against a weaker Drachma), and eventually, Greece would be able to see some economic growth.

But with the Euro – Greece doesn’t have this option. They’re subscribed to the same currency, and the same monetary policy that every other Euro state is stuck to. And for a country like Greece, this is downright disadvantageous as strong economies like Germany keep the value of the Euro high (on a relative basis, at least).

What we have in the European Union is the willful submission of every single nation’s monetary policy to a larger, more disconnected Central Bank in the ECB. In economics, the balance of monetary policy and fiscal policy is of extreme importance. Monetary policy is designed to have a half-life of a year or less, and this is what Central Bankers need to monitor. Fiscal policy, well, that’s up to politicians, and that’s what really brings impact within an economy. And if you’ve watched the news over the past six years, you’d probably have noticed that very few politicians around-the-world want to broach this incredibly complicated topic, and instead, want to rely on Central Bankers to use their theoretical credit cards to continue adding liquidity to keep things from melting down.

Hence, the world has been using monetary policy to try to fix a fiscal problem. This may just be one reason why none of this has actually ‘worked’ yet, in turning the global economy back on track of solid and consistent growth.

This whole theme almost came into capitulation in 2012, when the European Debt Collapse was ravaging its way through the European continent. The European economy bifurcated between the ‘haves’ and ‘have nots.’ The ‘PIIGS’ of Europe (standing for Portugal, Ireland, Italy, Greece and Spain), were teetering on the brinks of insolvency, and the strong economies in Europe didn’t want to add an implicit backing of support out of fears of contagion.

These PIIGS of Europe helped to keep the value of the Euro low for countries like Germany, so worries of inflation became very real as strong growth rates continued throughout German industry, driven by trade flows on the back of a weak currency. But for countries in Southern Europe that were facing economic headwinds, the Euro was still relatively strong and this made the possibility of using exports as a basis for recovery an unrealistic possibility.

So, at the time, it looked like the Euro was headed for an inevitable ‘pain-chain’ to a break-up. At least that was the fear, as we were basically land-locked from both a political and economic perspective. Countries in Northern Europe didn’t want to hold the bag for countries in Southern Europe, even though they were benefiting from the weak Euro that was driving their trade flows. And countries in Southern Europe, well they had no choice but to submit to the demands of the more dominating Central Banks in the ECB, and this is where forced austerity came in.

But none of this worked. And the deeper we got into the summer of 2012, the more realistic the prospect of a Euro break-up seemed to be. That is, until July 24th 2012, in a historic ECB meeting in which the head of the Bank, Mr. Mario Draghi, said that the ECB will do ‘whatever it takes,’ to preserve the single currency.

Finally, the ECB stepped up in the direction of more-complete European integration, and markets cheered this as they bid the Euro higher.

The Euro: From Whatever it Takes to Whatever it Must

Created with Marketscope/Trading Station II; prepared by James Stanley

The next two years saw the Euro move from 1.2000 to 1.4000 against the US Dollar as this confidence helped to drive reserve and long-term holding flows into Euros; as long-term viability was now significantly more attractive. There was only one problem: Monetary policy is not a panacea, and despite the fact that the Euro appreciated for two years, growth continued to languish, unemployment continued to stay at massively elevated levels, and, for all intents and purposes, we were looking at fear of contraction of many European economies as forced austerity continued to preempt cutbacks in government spending (which is traditionally a strong driver in Europe).

But something even more troubling began happening last year. As countries in Southern Europe appeared to be on the mend, with debt yields moving back towards realistic levels in-line with other developed nations, as opposed to the 6% and 7% Yields on Spanish and Italian debt that we saw in 2012, countries in Northern Europe started to slow down. What was previously the engine of European growth and stability were now looking at deflationary pressures and slower growth rates. An expensive Euro (approximately 16.6% higher than in 2012), was creating considerable weakness.

Take that Volkswagen that you bought in 2012 for $30,000. Back then, at a 1.20 spot, Volkswagen would be bringing back €25,000 into Germany. Now, at a 1.40 spot, Volkswagen is only bringing back €21,428. Same car, same costs (because their materials and workers are still paid in Euros), same product and even in the same market – and Volkswagen has to take on a 14% hit to their revenue just because of a currency movement. This was the proverbial straw that broke the camel’s back, because Europe was already teetering on the brink of disaster to the point where this additional point of pain was hardly tolerable.

I would suggest here, that this could provide motive for a company in this position to look at ways to save costs (such as with emissions tests), but given the scope of how long that was happening, this is likely an un-related, far more sinister issue going on. But for the European Union, this additional strength in the Euro was very unwelcomed.

With the global economy closing in on Europe from all angles, Mr. Mario Draghi, once again, stepped up to the plate in May of last year. He warned markets that the European Central Bank was standing by to institute a plan of some kind to provide liquidity (and hopefully, growth) to the European economy. The Euro made a quick move from 1.4000 to 1.3500 and then waited… it took two months, but when we finally got the announcement of European QE, this drove the Euro lower and prospects for a European recovery began to look up.

This created one of the more profound trends across currency markets of the past 10 years, as traders sold Euros ahead of an anticipated QE program that was expected to further dilute the Euro, while traders bought the US Dollar in anticipation of an eventual end to QE out of the US, followed by an eventual rate hike.

The Euro: From Whatever it Takes to Whatever it Must

Created with Marketscope/Trading Station II; prepared by James Stanley

These types of trends are a huge deal for an economy, because the currency that an economy uses is like the foundation of a house. With a weak currency, traveling to that country automatically becomes cheaper. That ~3400 pip drop in the Euro, driven by European QE, ya – that’s a 25% move. So basically, traveling to Europe just went on sale for 25% off for Americans (or anyone else using US Dollars). This also pads margins for European exporters, the exact opposite of the ‘pinch effect’ that we looked at with Volkswagen above. You can sell the same car, at the same cost, with the same resources and inputs, and automatically make 25% more if you’re VW because of the EUR/USD spot.

As you can imagine, this can be a big driver of economic activity. There is only one problem: That hasn’t quite happened yet.

While most of this year was spent looking for ‘grass shoots’ of a European recovery, the combined forces of a brutal slowdown in commodities, a potential meltdown in Asia, and the US hiking rates for the first time in nine years was enough to create a pullback in the global economy, and this began to raise numerous questions for the European recovery as a whole. The entire continent of Europe looked very, very vulnerable. German stocks began to pull back after the Euro had bottomed in March, as another Greek-scare questioned the viability of the European Union, yet again.

The Euro: From Whatever it Takes to Whatever it Must

Created with Marketscope/Trading Station II; prepared by James Stanley

But after Greek fears subsided towards the end of the summer, and as Chinese markets began to come back after a veritable artillery of stimulus appeared to have quelled the declines, the European Central Bank was back to square one: How to fix a fiscal problem with monetary stimulus? Despite the fact that stimulus was already running at full-steam, Europe still wasn’t growing. Like, at all. By most accounts, the economy was contracting, and we were seeing deflation throughout the continent, including in the honey pot of Germany. This, to be sure, was a troubling prospect.

But as has become customary, Central Banks are not willing to go down without a fight. At the October ECB meeting, Mario Draghi, again, stepped up to the plate and announced that the ECB was going to ‘re-examine’ their QE-outlay at the bank’s next meeting in December. This was largely inferred to be the bank’s acknowledgement that an extension or increase in the program was going to be necessary to continue that search for inflation. And very quickly, the Euro began to break lower. We had discussed this before-the-fact towards the end of September in the article, Is the EUR/USD Down-Trend Ready for Resumption, in which we showed traders two different indicators to look at to time the move.

The Euro: From Whatever it Takes to Whatever it Must

Created with Marketscope/Trading Station II; prepared by James Stanley

On December the 3rd, Mr. Draghi will step to the plate, once again at the ECB’s much awaited December meeting. Most signs point to an extension or an increase to the bank’s QE program, and just this morning we got the latest reminder that the European Central Bank isn’t anywhere close to done, as Mr. Draghi said that ‘we will do what we must,’ implying that they’re about to do something. Christopher Vecchio analyzed the comments in more detail in releavance to cross-market Euro activity in his morning piece, Draghi’s Dovish Reminder Keeps EUR/USD Downtrend Intact.

For now, look to play retracements in the down-trend in order to get an attractive short position going into that December 3rd ECB meeting. With a holiday-shortened week between here and there, we have a prime opportunity to see meandering price action while desks around the world (or at least the US) take the day off on Thursday in observance of Thanksgiving. Look for ways to sell the Euro in an advantageous way (managing risk, using comfortable stops, building positions, etc). On the below chart, we’re looking at some potential resistance areas that may offer short-side entries ahead of this December 3rd ECB meeting:

The Euro: From Whatever it Takes to Whatever it Must

Created with Marketscope/Trading Station II; prepared by James Stanley

--- Written by James Stanley, Analyst for DailyFX.com

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