When I saw the Wednesday (October 23, 2013) headlines screaming that European Central Bank (ECB) President Mario Draghi indicated he had no hesitation about failing banks in upcoming, comprehensive stress tests, I assumed the euro (FXE) would tumble fast and hard. European stocks responded as expected, in fact the plunge in major indices was the largest since late August. However, the euro barely blinked.
Here is a quote from a related Bloomberg article:
European Central Bank President Mario Draghi said officials won't hesitate to fail banks in its stress test next year as the ECB sets out to prove its vigilance in its new role of banking supervisor.
'Banks do need to fail' to prove the credibility of the exercise, Draghi said in a Bloomberg Television interview with Francine Lacqua in Frankfurt, after the ECB published plans for its bank-asset check. 'If they do have to fail, they have to fail. There's no question about that.'
Next up was the eurozone's PMI reading for services. The "expectation" was for a relatively healthy 52.2 but instead it came in at 50.9, scraping contraction levels. The euro responded with a quick dip and then a quick recovery, all within minutes. Overall, the euro sits comfortably at near one-year highs against the U.S. dollar.
A resilient euro has steadily climbed against the dollar since 2012 lows
An hourly chart paints some perspective on recent gyrations that do not show up in the above weekly chart.
The euro responds very favorably to US-related news and is relatively reticent about euro data
Finally, here is a chart of the iShares MSCI Spain Capped ETF (EWP) just to confirm that eurozone stocks were hit hard by the Draghi news. I chose EWP given I made a call earlier this year for a top in the ETF partially based on my skepticism about a second half recovery in the eurozone given the increasingly dire unemployment numbers. That top was challenged three months later and broken in another three months.
EWP finally pulls back after an intensely strong seven week run-up
Note that Wednesday's 2% pullback is a relative drop in he bucket compared to the near non-stop rally in EWP since the beginning of September. EWP is up a scorching 25% in 7 weeks and up 37% since the June/July and 2013 low. It has been an amazing turn-around in sentiment and price.
This resilience in the euro is the U.S. dollar's weakness. The U.S. dollar index (UUP) is dominated by the euro, and it is clear the euro has been a prime choice for betting against the dollar in recent months. On Tuesday, the index broke down below its QE3 reference price, the level of the index when the Federal Reserve announced QE3. It is an approximate support level I assumed would hold.
The U.S. dollar seems to be breaking down
Source for charts: FreeStockCharts.com
The main culprit for U.S. dollar weakness appears to be cooling expectations over the Fed's original plans to begin tapering by the end of this year. Given the fiscal fiddling and squabbling in the U.S. government, the Fed is not likely to even think about tapering again until sometime in early 2014, eons away for foreign exchange markets. The Fed is not only contending with the potential economic impact of the fiscal fiddling but also the government shutdown is delaying the production of the data they need to make such decisions. (I believe the survey for the October payroll numbers will not include the full month). Interest rates have pulled back and now appear to be stabilizing over the past three months.
U.S. interest rates have stop soaring higher and appear to be stabilizing
Source: St. Louis Federal Reserve
I still prefer to use the British pound (FXB) to bet against the U.S. dollar given I remain bullish on the UK economic recovery. I remain skeptical about the euro's rise, and I figure the currency is much higher than desired by the ECB given the still fragile nature of the eurozone economy. I have taken up fresh short positions against the euro using the Australian dollar and the British pound. I am still rolling out of my short AUD/USD position so, in effect, I am net long the U.S. dollar (and short EUR/USD). I am still undecided on how I will shake out in the coming week or so on the net U.S. dollar positioning. I am watching for follow-through on the current breakdown.
Be careful out there!
Additional disclosure: In forex, I am net short euro and net long U.S. dollar.