Why The Euro Is NOT Diving After The Italian Elections

Includes: FXE
by: Brian Kelly

Since today is tell a fairy tale day, I thought it was appropriate to use Orwell's classic as a framework - after all, the original title of the book was Animal Farm: A Fairy Story. So let me sum up the research on the Italian elections … it's bad. So why is the euro up? Here is where our porcine friend Napoleon can help. Mario Draghi has pledged to do "whatever it takes" to preserve the eurozone. Most market participants have interpreted the Italian election outcome as a euro negative - political uncertainty leads to higher bonds yields and a weaker economy, therefore the ECB must provide more liquidityor so the thinking goes.

However, the ECB has made it clear that monetary policy is not a political tool and it has been loathe to take action when political uncertainty has resulted in economic weakness. Following this line of thinking, the Italian elections have made it less likely that the ECB will cut rates in March. In other words, all animals are equal, but some animals are more equal than othersespecially the animals that follow the rules. But wait there's more

Since the July 2012 OMT announcement the euro has rallied every-time the threat of a breakup is extinguished.

(Click to enlarge)

Discovery (July 2012 - September 2012):Whatever It Takes Phase - From the moment Draghi uttered the phrase "whatever it takes" the market began to discover that the nature of the ECB had changed. The hard money Bundesbank had been neutered, as European politicians and central bankers realized that Germany needs the euro more than the euro needs Germany. This set up the current Whatever it Takes paradigm. (For an explanation of Why Germany needs the euro see the note Why is Germany So Happy and Europe So Sad?)

Paradigm Test #1 (September 2012 - November 2012): Doubt -This period was replete with doubt - the U.K. began to ask "should we stay or should we go" ;the IMF cut the eurozone's growth forecast; and Greece was on the verge of not receiving badly needed cash. The Whatever it Takes Paradigm was re-affirmed when a check was written to Greece - the eurozone was saved! (yep, you are detecting a bit of sarcasm)

Belief and Proof (November 2012-January 2013): It's Working! - In the last quarter of 2012, Europe appeared to be fixed - a plethora of news stories suggested the worst was over, politicians high-fived, and investors began to believe in the eurozone turn around story. The proof came on January 10, 2013 when the ECB did not cut rates and Mario Draghi gave a rosy outlook. Every type of investor had a reason to buy Europe - value investors loved the low p/e's; momentum found Draghi's ability to move the euro comforting; and even passive pensions began to reallocate.

Paradigm Test #2 (January 2013 - February 2013): Dubbio - The prospect that Berlusconi (or worse Grillo) may gain power has caused investors to question their belief in a unified eurozone. The Italian elections are providing the perfect opportunity for the markets to once again test the Whatever It Takes Paradigm.

Dislocation (February 2013 - ?): Tourista - It is possible that the Italian elections constituted a successful test of the paradigm and another leg higher is beginning. In this phase we would expect the economic data to deteriorate, yet the financial markets to continue to embrace risk. The Whatever it Takes paradigm means that bad news is good news and paradoxically the Euro could even rally when the economic picture darkens.

Why is this so?

Well there are really two outcomes to the current situation: 1) A broad coalition is formed, the euro rallies and the eurozone is savedagain or 2) political chaos ensues and Italian bond yields spike

Under option #2 one might expect the euro to drop, and indeed every analyst that I have read is predicting such an outcome - but the flaw in this logic is that rising bond yields play into the hands of the Germans who want more austerity. If political chaos leads Italy to activate the OMT it will come with conditions that will be even more restrictive. Since Italian politicians want fewer restrictions it is in their best interest to form a broad coalition. In this case, a successful test of the paradigm will have occurred and tourist investors may flood into the eurozone.

But what if your wrong? Your analysis assumes all the players are rational actors.

If I'm incorrect, then the eurozone will break up and Germany will keep the euro … which means the euro becomes the hardest, most stable currency in the world.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in FXE over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.