The last few months, we noticed that the euro had significantly outperformed the U.S. dollar since August 2012, right when QE3 was going to be announced (Chart 1). I see conditions in the Eurozone improving and soon the markets will focus on problems in the U.S. instead of the Eurozone. Therefore, I believe the uptrend in the euro will continue and I'll explain why.
As I pointed out earlier in this article, strong currencies are likely to have strong bond markets. So, if we see a strengthening bond market for a certain country, we can be almost sure that the currency of that country will appreciate in value against other currencies.
Let's take a look at the bond market of several key countries in the Eurozone: Germany, France, PIIGS.
As you can see, all of the Eurozone countries have improving bond markets. As an investor you could buy the WisdomTree Dreyfus Euro ETF (EU) to benefit from this trend.
On the other side, if we look at the 10 year U.S. bond yield, we see weakness (rising yields: Chart 9). The reason for this weakness is especially due to the QE3 program which is inflationary to the U.S. dollar. From 2013 onwards, the QE3 program will expand the balance sheet of the Federal Reserve by literally printing U.S. dollars into existence to buy U.S. government bonds in an amount of $45 billion/month. This is where the inflation will arise from and it is a fact that bonds will underperform all other assets in inflationary periods (Chart 10). I predict that the shift out of the U.S. dollar to other currencies like the euro will only increase in time.
In fact, the euro is doing so well that even gold has declined in value against the euro since November 2012 (Chart 11). November 2012 is the first month this year where we have seen a decoupling between the U.S. dollar and gold. Meaning that both the U.S. dollar and gold decline in value. Normally a weak dollar should be bullish for gold, but we didn't see that in November. A possible reason for this is that Europeans are selling their gold to go back into their currency as the structural problems in the Eurozone are finally subsiding.
Other evidence of an improving economy in the Eurozone can be found in the manufacturing PMI. The Eurozone still has a manufacturing PMI below 50, indicating a contracting GDP growth. But the trend is improving, while the U.S. has a deteriorating trend in manufacturing PMI.
Another important indicator, the current account (which measures foreign trade), can give information about the fiscal policy of a country. The better the current account of a country, the less reason for a country to have inflationary fiscal policies by the government, thereby devaluing its currency. As we can see on Chart 13 and Chart 14, the Eurozone by and large outperforms the U.S, posting a stable current account surplus against an increasing current account deficit in the U.S.
On the unemployment rate front, we notice that the media reports that the Eurozone has an unemployment rate of 11.7% , while the U.S. only has an unemployment rate of 7.7%. But don't be fooled, if we include discouraged workers into the equation we can conclude that the Eurozone has an unemployment rate of around 13% (Chart 15), while the U.S. has an unemployment rate of 15% (Chart 16). Note that Italy has the most discouraged workers in the Eurozone.
Finally, I want to point out that the currency greatly depends on the expansion of the balance sheets of the Federal Reserve Vs. the ECB. There is evidence that there exists a correlation between the EUR/USD and the ratio between their balance sheets. For example, when the balance sheet of the ECB expands more than the Federal Reserve's balance sheet, the euro will weaken against the U.S. dollar. Today the ratio between the balance sheet of the Federal Reserve Vs. the ECB is 0.95. We know that the Federal Reserve will increase its balance sheet to $4 trillion dollars at the end of 2013. At the same time we know that the European bond markets are improving a lot, meaning less need for increasing the balance sheet of the ECB. The result is that the ratio between Federal Reserve/ECB balance sheet will go up in 2013 and that will be bullish for the euro.
The market has already priced in the problems of the Eurozone and is now focusing on the problems in the U.S. QE3 will be much more expansionary to the Federal Reserve balance sheet as opposed to the expansion in the ECB balance sheet (due to the bailout of countries with bad sovereign debt). The fundamentals of the Eurozone are improving and improving Eurozone bond markets are reflecting this. All of this will be bullish for the euro going forward. Investors can bet on this by buying CurrencyShares Euro Trust (FXE) or the WisdomTree Dreyfus Euro ETF (EU). On a final note, we now eagerly await the Currency Composition of Official Foreign Exchange Reserves (COFER) report, which will be released at the end of this month. This will give an important indication on the currency composition held in the world.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.