First Euro Sell-Off In Weeks - What's Next?

Includes: FXE, UDN, UUP
by: Ralph Shell

For the first time in seven weeks the EURUSD (FXE UUP UDN) has had a decisive sell-off. After stumbling yesterday, closing at about 1.3340, the slide continued today, all the way down to 132.20. The catalyst for the sell-off appeared to be good US economic data. The weekly first time unemployment was as expected, 331K, and the Quarterly GDP (Annualized) was reported at 2.5%, better than the 2.2% guess.

Another driver in the overnight news was the cooling of rhetoric regarding the civil war in Syria. Yesterday Western leaders said the evidence was conclusive, Assad has used nerve gas on his people and deserved an immediate response. Today the New York Times and the AP both warned more time was need to reach a conclusion, providing cover for the administration to rescind previous hawkish plans.

There is also the concerns of Parliament and the House of Representatives. Both bodies need be informed, and military action by the US is supposed to be approved by the House. So much for a Thursday night missile show, but bellicose weekend war talk remains likely.

The steady stream of good US numbers probably means the Fed's taper is about to commence in September. Should next week's US Employment number and the NFP confirm the recovery is continuing, the taper talk will get louder. (The unemployment rate is forecast to remain unchanged at 7.4% and the NFP is estimated to be 175K.)

Some of the USD strength may have been as a result of safe haven demand as the world has taken sides and made threats over the Syrian situation. Perhaps the Syria haven buying will slow next week, but strong US numbers should help the USD.

Should the Fed say they are beginning the taper, reducing their monthly purchases of bonds from $85B to say $75B, what will result? Certainly this would favor the USD versus other currencies, but the Fed's actions will impact global markets.

Evans-Pritchard had some profound comments in today's Telegraph. The impact of the Fed's tightening will result in the contraction of the BRIC economies. In the 1980s when Volcker tightened the money supply, the emerging markets were less than 15% of the global GDP. Now according to IMF data, emerging markets account for half of the world's GDP. From the Telegraph:

"The big risk is that Fed tapering will spark a rush for US dollars. That is when the Fed will stop being complacent," said Lars Christensen from Danske Bank. "Central banks around the world think they have been doing something they shouldn't do with all this stimulus, and they want to unwind it as quickly as possible. But the danger is that they will go too far and trigger a relapse like 1937."

It is Evans-Pritchard's contention:

"The Fed has a duty of care to emerging markets, since its own hands are hardly clean. Zero rates and quantitative easing were the cause of dollar liquidity flooding these countries. It was the biggest reason why net capitals flows into emerging markets doubled from $4 trillion to $8 trillion after 2008, much of it wasted in a late cycle blow-off... One cannot blame the US for the failings of these countries, yet Ben Bernanke and his successor will still have to live with the consequences. Globalisation has entrapped the Fed. Like it or not, the Fed is the world's monetary superpower."

One of the age old adages is "you do not fight the Fed." Once the taper starts, it is likely to continue. Trillions of US dollars, available at near zero percent that had gone abroad yield shopping in the developing world, will head home.

If we look at the daily EURUSD chart, today was the first day we traded at the bottom end of the Bollinger Bands since early July when the low was close to 1.28. The weekly chart has had seven weeks of unchanged or higher markets. With one day until week's end, it looks like this will be the first lower week since the middle of July.

The summer has been quiet in Europe, perhaps in respect for Frau Merkel's political campaign. Once re-elected, problems will resurface. We note Merkel said it was a mistake for Greece to be given entry into the EU, this past week. Greece needs more money, quickly, so this may be the first post-election problem. The list of EU problems continues, and we expect they soon will be making headlines.

Our preference is the short side of the EURUSD. We note that during the last six weeks, our COT studies show the specs have covered 65K contracts of shorts, and gone long 43.7K contracts. This shift of positions no doubt was partially responsible for seven weeks of higher markets. We prefer to try the sell side if we recover to the 1.33 level, but we may adjust the entry level next week.

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. I have no business relationship with any company whose stock is mentioned in this article.