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Europe: There is Nothing Civil about Civil War, in Politics or Economics

Europe: There is Nothing Civil about Civil War, in Politics or Economics

Fundamental Forecast for Euro: Neutral

So how about that Euro, huh? After last week’s four-handle burst on the back of the ECB disappointment, many traders looked at this as a gift from markets: The potential to short the currency of an economy that’s facing significant headwinds without the ability to form a strong enough coalition to actually try to counter this weakness. This is yet another page in the story of what happens when a supra-national attempts to re-grow their economy.

You know, something similar has happened in the past: There’s a little economy that you may of heard of that initially started out as a loose coalition of states. It was a grand idea: let each state take care of their own concerns, and provide a loose overhanging Federal government to keep all of those states on the same page. This worked out pretty well for a little while, despite significant negativity on the concept from abroad. But as economic pressure picked up, that ‘loose coalition’ was ripped to shreds. These states and regions of states faced very different prospects: Different climates, different agricultural products, and different resources. Eventually, one group of states thought the other group of states was trying to take advantage of them and blew the whole thing up, or at least they tried, by succeeding from the Union. One Civil War later and we have the United States. Federalism won out, and the whole idea of a loose confederacy of states working together for the greater, common good turned out to be a ridiculous idea. When bad stuff happens, when people get worried – they don’t stay as concerned about their neighbor. They’re worried about their own survival. Just like what is happening in Europe right now.

150 years later the world hadn’t remembered much about that loose confederacy of states because it fizzled out in such an inglorious fashion. We saw this idea come together again in Europe with the creation of the Euro; a supra-national governing body attempting to regulate the economies of 18 member states simultaneously , without shared debt, without shared budgetary concerns and without shared banking processes all while trying to juggle different economic variables. One monetary policy attempting to co-manage the individual fiscal policies of 18 member states all with very different laws, inputs, economies, workers, populaces, etc. The 15 years of the Euro haven’t been too kind to the European economy, and it looks like we’re nearing a point of capitulation, of some type, as deflation rages across the continent and member states each face their own dizzying sets of concerns. Even the economies that have prospered with the Euro, like Germany, are beginning to face deflationary pressures.

Ironically, this is another North-South show-off, not too indifferent from what we saw back in the 1860’s. Each of these portions of the European economy have such starkly different drives and inputs that the idea of successfully managing all of these economies with one, single monetary policy (without any coordination of fiscal policies) is turning out to be a dizzying prospect.

Europe needs help to survive in its continued form; that much is already known. Investors around-the-world thought that help was coming in the form of a massive increase to European QE last week. Well, that didn’t happen. The fact that the ECB announcement was so incredibly weak (a small cut to deposit rate only, no increase to QE) raises questions as to how much dissension there is amongst finance ministers in Europe. To be sure, this isn’t a new idea. We saw much of the summer rage around the argument of what to do with Greece. Some European members wanted to kick Greece out of the Euro, others wanted to force more austerity down their throats (which seems to actually hasten these recessionary pressures) and others wanted to do whatever had to be done to save the Union.

The short Euro trade has been one of the most attractive setups over the past two years because of all of the reasons that I mentioned above. The European Central Bank was actively weakening the Euro with QE, and long-term, the prospects of the European Union’s survival in its current form were weak, at best. So this was one of those rare situations in which the intermediate-term trade lined up almost perfectly with the longer-term theme of Euro weakness.

In October, Mario Draghi stoked hopes for a huge increase to QE. This accelerated the short Euro theme. Now we had a signal that something was about to go down. Mr. Draghi made no fewer than three additional assertions in the following six weeks that ‘something’ was coming. And if we combine that with the numerous hints that Ms. Janet Yellen has thrown out to markets that a rate hike is coming from the Federal Reserve next week, short EUR/USD was clean setup to the downside.

And then, last Thursday, we saw the fizzler. We got nothing, and it’s likely because these European politicians couldn’t agree on what to do. At least that’s what the signal looks like. This isn’t too different from what helped to start the Civil War in the United States in 1861. Northern and Southern states couldn’t agree on how to steward the collective economy forward. Southern states wanted independence for each individual state. Northern states (the Union) wanted federalism with a simple state-structure that was subordinated to federal concerns (the greater good).

The rest you probably know: It didn’t end well for the South, but in the end, it was just a lot of unnecessary deaths on both sides because politicians couldn’t come to a consensus. This was the nadir; this is what we want to avoid.

So there are few reasons to be long the Euro right now, and this is what presents complexity in the week ahead: EUR/USD is continuing in a bullish stance. The technical formation does not agree with the long-term fundamental outlook. The techs and price action are what matters (because that’s what gives you margin calls), so we will retain our neutral call on EUR/USD for the week ahead, but with an asterisk… should longer-term resistance come in around the 1.1200-1.1300, there may be a short opportunity. At current levels, EUR/USD is considerably unattractive.

For those that do want to use this recent rip-higher to short the Euro at a better price – look to EUR/JPY. Another Central Bank that’ll be facing considerable heat in the months ahead is in Japan. While the ECB is looking at a difficult scenario the BOJ is staring at a downright abysmal scenario. Their pension fund just took a $64 Billion drawdown because their QE program ran out of bonds to buy and had to play the stock market. Volatility in August and September delivered a -5.5% drawdown that will likely give them pause before doing anything more in that regards. Pensioner funds being invested in the stock market rarely brings on good results for the people paying into those pensions. So, another round of BOJ easing could be a distant prospect from the current point, and that means that there is a lot of Yen weakness that has yet to come out of the market.

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.