I am not sure why the euro (NYSEARCA:FXE) bounced on Mario Draghi's comments yesterday. It could just be a one day out-of-line movement to shake the weak hands out of their positions or traders simply took the lack of any additional easing announcement as confirmation that Europe and the euro are okay. The fact is Europe is in trouble and Draghi said so in his statement yesterday:
Available data continued to signal that economic weakness in the euro area has extended into the beginning of the year, while broadly confirming signs of stabilization in a number of indicators, albeit at low levels…. The GDP outcome for the fourth quarter of 2012 was weak, with Eurostat's second estimate indicating a contraction of 0.6 percent quarter on quarter. The decline was largely due to a fall in domestic demand, but also reflected weak exports.
This is about as negative a statement on an economy as you'll hear from a central bank official. Looking over some of the economic data provided by Eurostat and summarized in heatmap format on macrochart.com, the picture is not pretty.
Many months in deep red which means accelerating contraction of economic activity. The unemployment rate has risen over 1% over the past 12 months. Retail sales have barely registered a pulse. Industrial production is -2.5% year over year. The PMI indexes haven't had a reading over 48.6 in a while (reading over 50 means expanding economy). Most of the manufacturing readings are near the depressionary level of 45. The only bright spots are the recent sentiment numbers, but even they are below the reading from last year around the same time. And in any case, any European sentiment survey has to taken with a grain of salt. In Europe, the house may be burning, but people will smile and say the world has never been better.
What could provide cover for Draghi, if he wants to engage in additional easing, are the bad inflation numbers. The Consumer Price Index is down -0.8% over the last 3 months, with the January number at -1.0%. The PPI numbers are not providing much boost either. Europe is fighting deflation or at the least non-inflation. In today's leveraged society, deflation is to be avoided at all costs. Just ask Ben Bernanke and I am sure Mario Draghi will wholeheartedly agree.
The Lessons of the Weimar Republic
One of the most fascinating economic readings I have encountered is the description of the hyper-inflation during the times of the Weimar Republic in Germany in the early 1920's by James Rickards in "Currency Wars: The Making of the Next Global Crisis". People would pay their dinner in advance because the price would be so much higher by the time they finished their dinner! Turbulent times indeed and we have never encountered anything quite like this here in the USA. Jean-Claude Trichet often talked about how the lessons of the Weimar Republic shaped his policy outlook. Well, the reality is that there is nothing to be learned from that time period. The Germans had just lost World War I and were saddled with massive war reparations in the Treaty of Versailles. The French insisted that the Germans pay for all the damage encountered during the war and created reparation bonds to the tune of 132 billion German gold marks. Faced with burdensome debt obligations that would have incapacitated the German economy for many decades to come, the Germans decided to devalue the reparation bonds which were denominated in the German gold mark. By introducing hyperinflation, the Germans were able to repay a significant portion of their war debt within a few years until the Hoover Moratorium ended reparation payments altogether. With reparations behind their back, Germany enjoyed spectacular economic growth during the Hitler years. That is it. There is no "lesson". The hyperinflation policy was not some kind of a mistake. It was a deliberate attempt by the Germans to stick France with a pile of worthless paper. For a long time, this "lesson" has provided cover for ECB officials to keep the euro much stronger than it should be. I think those days are now numbered.
The Franco-German Divorce
The never ending story of one-upmanship between Germany and France lives to this day and under the unified surface of the European Union, a vicious political and economic war is being waged for the allocation of scarce capital. The German export based economic model is viewed with envy by the French and they realize that their companies cannot compete head on with the German juggernauts. The German insistence on austerity and strong euro is in direct contrast to the usual avenue that the French have employed throughout their history to boost their economy - the printing and weakening of the franc. The French economy has suffered dramatically as a result. Over the past year, Germany and France have walked vastly different economic paths.
While German net exports average more than 15 billion euros per month, France is a net importer at about 5 billion euros per month. While the German economy is recovering nicely with the latest PMI Services well above 50 at 54.7, the PMI Manufacturing number in France is bouncing around the bottom with a depressionary reading of 43.9. The French are certainly not helping themselves by raising the income tax rate to 75% on top of their already high 33% corporate tax rate (Germany is at 45% and 30% respectively).
Fortunately for the French, the Germans are losing the argument as austerity has brought on massive instability in the countries where it has been successfully implemented and the strong euro is exacerbating already flagging exports for the Eurozone as a whole. It is now clear more than ever that austerity and strong currency is not the answer that fits the European population. While Europeans like the prestige that comes from having a strong currency, they certainly will not like its ultimate effect - stagnating economy, rising unemployment and protests on the streets. Recent elections in France and Italy have been a direct vote of no-confidence against austerity and we should expect more and more government bonds to be issued in Europe over the summer to pay for expansion of government cradle-to-grave programs, infrastructure, green energy and other spending programs. Mario Draghi and the Germans have been cornered and they will ultimately have to acquiesce to a massive increase in the monetary base and the money supply at the ECB. It will not happen today and it will not happen tomorrow, but the September 22nd election in Germany will provide plenty of opportunity to discuss this issue and we will be provided with significant headlines over yet another summer of discontent in Europe. There is only one way out for Draghi and as the lessons from the Weimar Republic get slowly unlearned during the course of the summer, the value of the euro has only way to go and it is down. The question is how far down.
The CurrencyShares Euro Trust is an excellent way to play the Euro-Dollar exchange rate, if you don't have a brokerage account that can trade currency pairs. The ProShares Ultra Short Euro ETF (NYSEARCA:EUO) is another way to play it on the short side with 2 times leverage. The FXE has been in a long-term down trend, albeit with violent snapbacks.
On this 6 year monthly chart, it is apparent that the euro has been making lower highs since the summer of 2008. The last major wave got rejected at the 50% Fibonacci retracement and the recently completed month of February completed a massive bearish engulfing pattern, only one of the strongest reversal patterns according to the book of Japanese Candlestick Charting Techniques. The last time we had a bearish engulfing pattern was in December of 2009. Following that, the FXE lost 30 points in the next 6 months. I would not be surprised if a similar type of move develops over this summer. Many experts tag the fair value of the euro at $1.15 based on economic fundamentals alone. I would not be surprised if the market overreacts and pushes the euro all the way down to $1.05 which is where a loss of 30 on the FXE would put it. Let's not forget, the US monetary easing policy has run its course. Bernanke will not be announcing any new QE this year. If anything a stronger economy and job growth will make the hawks at Fed start talking more aggressively about strengthening the policy. Any turbulence in the S&P 500 (NYSEARCA:SPY) over the summer will also add to dollar strength as piling into the US dollar (NYSEARCA:UUP) is now probably the preferred risk-off trade of professional money managers since US treasury bonds (NYSEARCA:TLT) are in a downtrend right now. At the same time, as long as the US grows stronger and Europe grows weaker, with each passing month the pressure on Draghi to devalue the currency will build exponentially. May be he didn't announce additional easing yesterday, but soon he just might have to.
This is about as clear of a short as I could find in a long time. If you have $10,000 to invest in a trade like this, I would suggest doing the following. Buy $2500 of EUO tomorrow. Watch for any bounce-back in the FXE to the 130 level. It attempted to cross it on Thursday and got rejected. If it moves above 130, close out the position for a slight loss and wait for the reaction to exhaust itself before resuming the trade.
Upon a second rejection of the 130 level, buy $5000 of FXE January 14 out-of-the-money puts with 125 strike. If the FXE closes below 127.50 which has been a major support level for the past 6 months, sell your EUO position and invest the proceedings and your remaining cash into more FXE 125 Jan 14 puts. If the FXE gets to the 120 level this summer, your puts will be now in-the-money and the time-value decay will be less of a factor. You are looking at least at doubling your money and potentially much more. 120 is a major support level and if that gets broken, you are looking at even bigger profits. If you think such a big move can't happen, did you witness what happened to the yen (NYSEARCA:FXY) over the past 6 months?
Disclosure: I am long EUO. 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.