At any time there are innumerable factors impacting stocks, bonds or currencies. The challenge for investors is to figure out what matters most. I started writing about the euro (FXE) towards the end of the Cyprus crisis. Since then the euro has been surprisingly strong versus the US dollar, despite many good reasons for it to weaken: economies in recession, high unemployment, troubled banks, high debt levels and more. However, external factors seem to have exerted more power on the euro than internal factors. The massive quantitative easing (QE) programs in Japan and the US are providing liquidity and driving some investors to Europe for yield. Furthermore, the ECB's lack of money printing compared to the US Federal Reserve is supporting the euro versus the US dollar. The external factors, however, may start to lose their grip. In this article I will discuss the dynamics impacting the euro as well as the price action of assets across Europe.
The ECB has been on a roll. On May 2, the ECB cut interest rates. The interest rate cut was not surprising to many market participants, but it did seem to come sooner rather than later. The real news came from the press conference when Mario Draghi said that the ECB was considering negative deposit rates for Eurozone banks.
Then Draghi raised hopes by saying that the ECB may consider buying asset-backed securities (ABS) to help spur lending in the Eurozone. Draghi's statement may have been taken out of context, but he did mention that buying ABS was an option and invited speculation.
Mario Draghi has stated for a while that the ECB already did most of what it can to help the Eurozone economy and European politicians need to take more action to boost economic growth. However, the ECB's recent actions and comments are raising expectations that the ECB will do more.
At the same time there is growing backlash against austerity. The Germans' position is that struggling peripheral countries need to focus on fiscal restraint to bring down their deficits. The peripheral countries have been pushing back on this for a while, but two events are giving momentum to the anti-austerity movement.
The election in Italy was a vote against austerity and Italy is big enough to have some ability to push back against Germany. Furthermore, the Cyprus crisis gave austerity a very bad name. (The issue in Cyprus was not austerity per se, but the pro-austerity Germans did get much of the blame for the collapse of Cyprus.)
It will be interesting to see how these dynamics continue to play out. Will the ECB launch a European version of QE? Will peripheral countries ease up on the fiscal drag?
A shift toward internal dynamics could lead to a weaker euro. Just looking at the recessionary conditions in the Eurozone would suggest a lower euro. Furthermore, a money printing ECB would also likely push the euro lower.
However, European economic weakness is already much talked about and maybe priced-in. If the internal dynamics succeed in generating growth the euro may stay at its relatively strong levels.
Euro Price Action
The euro has been mostly range-bound for the last month. It has been trading around its 20, 50, 100 and 200-day moving averages, which suggests much confusion about the direction of the next big move.
Interestingly, the euro barely reacted to the ECB rate cut.
Late last week the euro traded down from the top of the month-long range on expectations of news from Mario Draghi and the G-7 conference over the weekend.
Additionally, rumors emerged on Thursday about a Wall Street Journal article on the US Federal Reserve and the potential for ending QE. The article came out late Friday, Fed Maps Exit From Stimulus, and doesn't seem to indicate change is imminent. As mentioned above, the euro is being supported because the ECB is falling behind the Federal Reserve in terms of money printing and it may weaken if the Federal Reserve cuts back QE.
European Sovereign Bonds
Late last week German bonds sold off and yields increased. This may have been in sympathy with a similar move in US Treasuries or on expectation of news from the G-7 meeting.
However, bonds for the peripheral countries held up well.
On a longer time frame, there has been a huge rally in European bonds, which has driven yields down. This rally is due to a number of factors, including the Draghi Put last summer and global QE, more recently. The inflows into European bonds has been a positive for the euro.
European Equity Markets
The big story in European equity markets was the new highs on the German Dax index. Despite all the problems in Europe, German equities have fully rebounded from the financial crisis lows.
The following chart shows the five-day price action for the iShares MSCI Germany Index Fund (EWG), iShares MSCI Italy Index Fund (EWI), and iShares MSCI Spain Capped Index Fund (EWP), and the SPDR EURO STOXX 50 ETF (FEZ). (Please note that the EWG tracks the MSCI Germany Index, which is different than the Dax.)
Performance across European equity markets was mixed last week.
On a year-to-date basis, the EWG, EWP and FEZ have returned to positive territory (The EWI, representing Italy, isn't there yet, but close).
Last week the European financial sector outperformed the broader market.
I am long Banco Santander (SAN), which had another tough week and underperformed the financial sector.
Banco Santander recently switched CEOs and the Spanish market underperformed its peers last week.
Here is a closer look at Banco Santander.
Impact of European Equity Markets on U.S. Equity Markets
The European equity markets almost caught up to the S&P 500 on a trailing three-month basis.
The probability of Europe acting as a negative catalyst for the S&P 500 seems low over the near term.
The euro has been range-bound over the last month and lacks a clear trend. It has been surprisingly strong and seems to have benefited from external factors, such as global QE. Global QE also supported the European bond and equity markets.
Now the question is what will be the catalyst for the next move. It could be that internal dynamics will take over. The ECB may be laying the groundwork for a new program and the austerity movement may be losing ground to the pro-growth movement. Each of these dynamics could be used as arguments for a weaker euro, but if they succeed in boosting growth the outcome may be different.
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