The fundamental story surrounding the eurozone reflects a region where countries are either falling into recession or already there. GDP data released last week showed France and Italy continuing to contract and Germany on the brink of negative growth. The U.S. - German yield differential is pointing to a lower euro (NYSEARCA:FXE), which could benefit the region by facilitating export-led growth.
May 15th's release of European economic data proved to be disappointing. France and Italy's GDP both contracted, putting France into a technical recession. France's first quarter GDP declined by 0.2% compared to the 0.1% expected and 4th quarter GDP was revised lower to -0.2% from the -0.3% expected by economists. Italy contracted by 0.5%, lower than expectations.
These negative reports give fuel to the thesis that the ECB will make good on its threat to lower interest rates further, and potentially put them on a path that is similar to Japan. The market is pricing in lower yields in Europe (NYSEARCA:BUNL), which should outperform U.S. long-term yields on a relative basis, as exemplified by the iShares Barclays 20+ Year Bond ETF (NYSEARCA:TLT).
The prevailing wisdom is that the eurozone would benefit from a weaker euro and lower interest rates. A policy in the EU that had quantitative easing targeting inflation similar to what is being done in the U.S. and Japan would likely generate a surge in the EU equity markets and put them on the same path to a hollow recovery as we've seen in the U.S.
Over an extended period, the correlation between the yield differential comprised of the U.S. 10-year yield and the German 10-year yield (NYSEARCA:BUND) versus the EUR/USD currency pair is high. Over short-term periods, the correlation will break down, but the ratio generally reverts back to the mean. With the yield differential contracting below support levels near $1.21, the currency pair is likely to follow given the negative sentiment associated with the eurozone.
A decline in the euro would be beneficial to export led economies which include Germany. The current problem for Germany is the intense price competition that is occurring from the aggressive devaluation of the yen. Germany is an exporter, but much of its exporting is done within the EU, which is part of the mechanism by which they have hollowed out the economies of the weaker peripheral states like the PIIGS. And it is not as if the Germans are unaware of what these effects are. At a policy level, they are driving the ECB's actions, creating the very instability that Angela Merkel rails against, much to the delight of the German electorate. So, the yen devaluation is creating problems for Germany as they share the highest Export Similarity Index with Japan, according to the IMF.
Further retaliation by Germany and the ECB is inevitable now that the yen has broken through ¥102 and looks to be headed higher. While this is putting pressure on the EUR/USD cross in Europe's favor, it is also destroying the value of the ECB's balance sheet by being bearish for gold (NYSEARCA:GLD). Remember, the ECB, unlike Japan and the U.S., marks its gold reserves to market so an attack on the price of gold - and the great vacuuming of it out of western vaults to eastern vaults - is a further attack on the euro and, by proxy, the Bundesbank.
The decline in the currency would have the effect of goosing the European equity bourses such as the DAX, which has already seen a robust rally (nearly 17%), but so what? It's like asking the S&P 500 (NYSEARCA:SPY) to go higher but not on fundamentals and growth but rather simply hot money flows and momentum-chasing hedge fund algorithms pushing select asset classes higher until they go parabolic.
The key level to watch this week is $1.275 on the EUR/USD. This will be the third foray to that level in the past 2 months. If the Fed is serious about tapering back its bond buying program, it is doing so to further break the back of the gold market and create fear in the eurozone to support the dollar as the exodus from it in international trade continues to unfold. The current German/U.S. bond spread is helping to support this thesis.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.