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The euro/USD (NYSEARCA:FXE) broke down from a month-long trading range and drifted lower last week. At the same time, European equities (and bonds) traded up and the Frankfurt DAX again closed at a record high. European economic news suggested weakness, including Q1 GDP contraction in France and minimal GDP growth in Germany. A soft euro had been a catalyst for weakness in global markets, but the divergence between the euro and European equities may suggest otherwise. This divergence seems to indicate that investors are expecting more action from the ECB, which would likely weaken the euro even more but benefit European stocks and bonds. In this article I will examine the recent trends in Europe and the implications for the euro.

Euro Diverging

The following chart compares the euro (represented by the FXE ETF) and the iShares MSCI EMU ETF (NYSEARCA:EZU), a proxy for European equities, since January 1, 2012.

Last summer the euro and European equities declined together, but more recently they are trading in opposite directions.

FXE Chart

FXE data by YCharts

ECB Watch

In my previous article about the euro I discussed that the diver for the euro may be shifting from external factors (quantitative easing in Japan and the U.S.) to internal factors, such as the potential for more ECB action and economic data (see Will An Internal Or External Catalyst Drive The Euro's Next Big Move?).

There was a lot of news last week that may suggest that the ECB is getting ready for more action. It is important to note that the ECB will probably not embark on a QE program like in the U.S., but may pursue other policy actions.

France officially slipped back into recession as Q1 GDP growth dropped -0.2% (here). German Q1 GDP growth only increased 0.1% and overall GDP in the euro area contracted -0.2%.

In his last press conference, Mario Draghi said that the ECB's monetary policy easing has more of an impact on core European countries as opposed to peripheral countries. The Q1 GDP weakness in core Europe gives the ECB a good reason to cut rates further and pursue other policy actions.

The weak GDP numbers add urgency for the ECB to act because inflation is low and declining. As of April, the inflation rate was 1.2%. Inflation is the ECB's primary objective and it will likely need to act to ward off the threat of deflation.

(click to enlarge)

As I mentioned last week, the ECB seems to be moving at a faster pace. The rate cut seemed to come sooner than expected. Furthermore, there is increasing chatter about the ECB launching a program to buy asset backed securities (ABS) to help lending conditions in Europe.

The gathering rumors and speculation about further ECB action seems to be the driver for euro weakness.

Euro Price Action

The euro closed the week at $1.28. From April 5, to May 10, the euro traded in a tight range in between the 20-, 50-, 100- and 200-day moving averages, but then drifted lower. The move away from these levels could be the start of a big move lower.

The $1.26-$1.29 zone has been an important level over the last few years. During the Europe crisis last summer the euro broke through this zone to the downside. However, during the Cyprus crisis it marginally breached the zone before bouncing back. The euro is now back in the zone and may be headed quickly to the bottom around $1.26. Importantly, this time the euro is not trading down because of a big crisis.

The euro has now given up the gains from the post-Cyprus crisis bounce. That bounce was also aided by global liquidity coming from QE in Japan, and to a lesser extent in the U.S.

(click to enlarge)

(Source: FreeStockCharts.com)

European Sovereign Bonds

There were some interesting movements in the European sovereign bond markets that I follow.

Last week, yields on the German and French 10-year bonds declined, as prices increased, while yields for Spain and Italy were unchanged. However, the big moves came from Portugal and Greece, which saw big declines in yield.

These moves came as Fitch upgraded Greece's credit rating to B- from CCC (here).

I wonder if the rally in Spain and Italy's bonds is coming to an end as their bonds did not move up with the stronger or weaker parts of Europe last week.

The big picture continues to be that Europe's sovereign bond markets are much healthier than there last year, which may be a positive for the euro as global investors seem to be investing in European bonds as they search for yield.

(click to enlarge)

European Equity Markets

European equity markets were mostly up last week and the DAX again closed at an all-time high. However, the Spanish market lagged.

The following chart shows the five-day price action for the iShares MSCI Germany Index Fund (NYSEARCA:EWG), iShares MSCI France ETF (NYSEARCA:EWQ), 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

EWG data by YCharts

On a year-to-date basis, all these ETFs are now in positive territory after they rebounded from the losses leading into the Cyprus crisis.

EWG Chart

EWG data by YCharts

European Banks

There has been a lot of news about European banks lately. In general, they are benefiting from the rally in sovereign bonds and the improving capital market conditions.

Last week, Commerzbank (OTCPK:CRZBF) launched a rights offering (here). This follows the $3.9 billion offering from Deutsche Bank (NYSE:DB) (here). It is a good sign that these banks are using the strength in the markets to raise capital.

Furthermore, new rules in Spain are forcing the banks to reclassify their problem loans (here). This will probably be a positive for Spain and Spanish banks in the long term, but could hit earnings in the short term and may accelerate additional capital raises.

The following shows the year-to-date performance for the iShares MSCI Europe Financials ETF (NASDAQ:EUFN).

(click to enlarge) (Source: FreeStockCharts.com)

I have a position in Banco Santander (NYSE:SAN) as a play on the European banking sector. Banco Santander underperformed last week.

(click to enlarge)

(Source: FreeStockCharts.com)

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

The euro and European markets are not serving as a catalyst for global declines like last summer.

The following compares the S&P 500 (NYSEARCA:SPY) and the Financial Select Sector SPDR ETF (NYSEARCA:XLF) with their European counterparts, the EZU ETF and the EUFN ETF.

The European markets are catching up to S&P 500 after some weakness a few months ago.

SPY Chart

SPY data by YCharts

Conclusions

The euro is drifting lower from a month-long trading range. However, unlike previous periods of euro weakness there is no crisis in Europe. Furthermore, the move by the euro represents a divergence from the strong equity and debt markets in Europe. The action by the euro and these other asset classes seem to indicate that investors are expecting more action by the ECB.

The economic data last week, as well as declining inflation, are setting the stage for a potential move by the ECB. There are rumors and speculation about the ECB buying asset-backed securities. Over the summer we will see if the ECB actually pursues this course.

After a period of relative strength, thanks in part to the end of the Cyprus crisis and global QE, it looks like the euro is headed lower.

Source: Euro And European Equities Diverging: Sign Of More ECB Action?

Additional disclosure: I may trade any of the securities mentioned in this article at any time, including in the next 72 hours. Also, I am long SPY puts, which stand to gain in value if the SPY declines.

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