Euro Strength Continues: Will Investors Rotate To European Assets?

| About: CurrencyShares Euro (FXE)

Cyprus has faded from the headlines and the euro (NYSEARCA:FXE) is showing surprising strength. The euro closed the week at $1.31, above several key levels. The economy of the eurozone is weak, but in the short term there may be other factors influencing the euro. In fact, the big story in the currency markets is the yen and the Bank of Japan's new monetary policy. In the race at the printing press, Japan and the U.S. are sprinting ahead of the ECB. In this article I will examine the price action of the euro and key European bond and equity markets. The weakness in the eurozone will catch up with the euro at some point, but until that happens I am looking for select opportunities in Europe.

Printing Press Races

Credit Suisse put out an interesting slide about the balance sheets of the ECB, the Federal Reserve, Bank of England and Bank of Japan (seen here, via Sober Look). Over the last few years these balance sheets have increased as a percentage of the nominal GDPs of their respective countries. Going forward, however, only the ECB is not growing its balance sheet. Clearly, the ECB is falling behind in the printing press races.

At some point the ECB will need to catch up to stimulate the European economy. It has room to lower interest rates and will probably do so in the next few months. The ECB has also hinted about "non-standard" measures, which implies balance sheet growth (but in a different form than the Federal Reserve's QE program). Some are expecting that the ECB will take action at its next meeting, but I am not sure about timing. The euro may start to weaken when the ECB catches up with its central bank peers. Until then it is benefiting from a lot of liquidity in the system and no major crisis in its borders (yet).


I discussed Cyprus in detail in my previous articles, so please see those for reference. Although Cyprus has faded from the headlines, it still faces challenges. Pimco's Mohamed El-Erian addresses Cyprus here: "Cyprus Rescue: From Bad to Worse." Right now, Cyprus problems do not seem to be spreading. But, it is important to watch for any changes.

Euro Price Action

The euro closed the week at $1.3108. It is now clearly above the $1.26-$1.29 band that I have been watching for a while. Also, it is above the 20-, 50- and 200-day moving averages and seems to have broken out of a downtrend starting in February. On this timeframe, the euro seems to turned the tide from a technical perspective.

Click to enlarge images.


European Bond Yields

The European bond market continued to show strength last week, especially the bonds of the peripheral countries. I added France and Portugal to my weekly chart to give more perspective. The yields on the Spanish and Italian 10-year are comfortably below 5%, especially the Italian 10 year at 4.33%. Again, signs of contagion from Cyprus or Slovenia are not showing up in these numbers.


European Equity Markets

The European equity markets had a nice rally last week. The following chart shows the five-day price action for the iShares MSCI Germany Index Fund (NYSEARCA:EWG), iShares MSCI Italy Index Fund (NYSEARCA:EWI), and iShares MSCI Spain Capped Index Fund (NYSEARCA:EWP), and the SPDR EURO STOXX 50 ETF (NYSEARCA:FEZ).

EWG Chart

The European banking sector outpaced the gains in the broader market. The following compares the iShares MSCI Europe Financials ETF (NASDAQ:EUFN) with the iShares MSCI EMU ETF (BATS:EZU).

EUFN Chart

I continue to follow Banco Santander (NYSE:SAN) as a possible play on short-term/mid-term strength in Europe. I haven't invested yet, but it is on my watch list. Banco Santander had a good week, but trailed the EUFN ETF.

EUFN Chart


Impact of European Equity Markets on U.S. Equity Markets

The S&P 500 (NYSEARCA:SPY) and the Financial Select Sector SPDR ETF (NYSEARCA:XLF) outpaced their European equivalents over the last few months. However, last week was a strong week across the board. The European markets were a catalyst for a correction in the S&P 500 last year, but that does not appear to be the case now. If investors want to take a "sell in May and go away" approach to the S&P 500, there may be rotation to Europe. If the ECB finally catches up with the Fed and BoJ at the printing press, European equities may benefit even if the euro suffers.

SPY Chart


There are many good reasons to be bearish on the euro on a long-term basis. However, it has been surprisingly resilient and closed last week above several important levels. The ECB is falling behind its central bank peers at the printing press, which may be supporting the euro for now. I expect that the ECB will lower rates and launch some sort of QE program, which could be a negative for the euro when it happens. In the meantime, bonds of the peripheral European countries have been strong and European equity markets had a nice move last week. I wonder if investors will rotate assets into Europe if they want to take money off the table in the U.S. Europe faces many problems and its economy is weak, but European security prices are showing short-term strength.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SAN over the next 72 hours. I may trade any of the securities mentioned in this article at any time, including in 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.

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