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Last week saw a lot of action coming from central banks around the world. The Bank of Japan shook investors with the commitment to double the size of its balance sheet in the year, the Federal Reserve taking the wind out of the sails of many who believed interest rate increases would happen this year, and the Bank of England concerned that the British economy could have fallen back into a recession in the first quarter. Meanwhile the European Central Bank, the region with slowing growth, high unemployment, and falling inflation, remains just "ready to act."

The ECB is treating this "slowdown" as a mere cyclical issue, waiting for a pickup in growth to offset the declining growth rate. In fact this is a structural issue that stems from the push of austerity by core countries and the lack of lending from banks in need of raising capital controls to stem the fragmentation of the regions as we are starting to see with issues like Cyprus. These types of issues will continue to compound if there isn't a policy shift to stop the decline and turn the region back towards growth. Should the desired remedy of the European depression be provided, it will bring a drop in the Euro, but so will simply doing nothing.

(click to enlarge)Unemployment continues to rise

There are fundamentally two reasons the currency could drop from this point, one with a negative correlation to the stock market and another with a positive. In the negatively correlated scenario, the ECB and the EU governments take the necessary actions to have the currency devalued through stimulus. This will be a positive for the markets as well as emerging markets (some periphery countries can be considered that as well) and the currency will devalue as a result of the stimulus measures. The positively correlated scenario will see the Euro drop as investors start to question the validity of the region's recovery and the political action required to sustain the confidence in the single currency. Naturally this will see a lot of the safe haven assets come back into favor (as we have seen with the 10-year treasury).

(click to enlarge)Inflation remains tame and below target

To elaborate more on the dual methods in which the EUR can decline, two conditions will emerge that I will refer to as a negative correlation to the markets and a positive correlation. The negative scenario will be based on stimulus coming into the markets from the EU, which could include a combination of asset purchases as well as increased spending and lower interest rates. This will lead to the EUR becoming a funding currency and putting pressure on the value to higher yielding/higher growth assets. The positive correlation scenario is where a lack of action in the EU keeps the region in contraction and causes the currency to decline as money in search of stability starts to flee back into safer assets in non-Euro denominations.

To play a negatively correlated scenario, the Germans would have to accept lower interest rates and higher inflation to allow more indebted countries to manage debts and push banks and companies to put their cash to work. I would suggest looking into banks and cyclical stocks to purchase while hedging out the FX risk. The Wisdom Tree Inter Hedged Equity Fund (HEDJ) would be a good fit for a broader play. The positively correlated play will see the euro continue to become more fragmented and eventually bring the single currency back into question. This will cause cross country lending to become more fragmented and business investment to be more localized. For this I would suggest a short on many of the periphery indices and not hedging FX. Banks in the region will also take a hit.

(click to enlarge)

In reality the positive correlation scenario will be the most likely to occur in the first place, forcing the hand of eurozone leaders into entering the devaluation cycle that most other developed countries are undertaking now. Then the ECB would have to react with a cutting of the interest rate and a general lowering of yield to be in line euro wide. This will be achieved with an increase in lower interest rates through inflation and a decrease in higher interest rates through purchases. The best overall play would be short the euro, such as with the CurrencyShares Euro Trust (FXE).

Source: Long-Term Downside To The Euro