Lessons, Conclusions, What To Do
The following is Part 2 of the article by the same title.
In Part 1, we explained the full implications of the chart below, and the risks implied, as well as for links to our article on some likely outcomes for the EUR and ECB..
Source: Michael Leister, Senior Rates Strategist, Commerzbank, via businessinsider.com 09 dec 31 1655
The key points were that EU banks have been using their cash to buy EU government bonds rather than to make commercial loans. The key problems stemming from that focus is that EU banks are:
- Hampering EU Growth And Raising Deflation Risk: Too much sovereign bond issuance and purchase by their domestic banks and other EU banks has crowded out private sector borrowers (the ones who ultimately create the jobs, spending, taxes, growth, etc.). This lack of private sector lending exacerbates the EU's slowing growth (ex-Germany) and the threat of deflation that further hurts growth. The second chart below merely confirms the decline in commercial lending.
- Raising Risk Of Another Banking Crisis: The accelerating rise in the amounts of GIIPS and other EU sovereign bonds as a proportion of total EU bank assets raises contagion risks from any single bank or sovereign insolvency, tightening the inter-dependence (or link, aka "doom loop") between EU governments and their banks that has been at the heart of most EU crisis and bailouts (of both banks and GIIPS governments). These risks are compounded by the EU's new single resolution mechanism (SRM), which not only fails to address existing systemic risks in EU banking, it actually makes them worse (see here for details).
See Part 1 for a full elaboration of these points.
Here in Part 2 we discuss the lessons, conclusions, and practical steps that traders and investors should consider taking.
Lessons And Conclusions
Here are the key take away points.
First, contrary to consensus opinion, the risk of a new bout of EU crisis is rising, not falling. If we then consider the following, it's much higher.
1. Europe's liquidity problems are getting worse, to the point that the ECB has had repeatedly been unable to sterilize portions of its secondary market bond purchases (SMP) because banks prefer holding cash over ECB bonds) so that the EUR money supply is quietly expanding. Meanwhile that lack of ready credit is hampering the private sectors' weak recovery.
2. The coming ECB bank stress tests further reduce liquidity and increase deflation, as banks hoard cash and top tier capital in preparation for those tests.
3. When the next bank failure occurs there is no functioning SRM program, only the OMT that no one wants to use.
4. That means we must now once again doubt the credibility of the coming ECB bank stress tests. The ECB will not knowingly risk starting a crisis by failing banks for which there is no backup plan.
5. The SRM's officially enshrining depositor, bank shareholder and bondholder bail-ins as the first source of funding for a troubled bank means that we have increased risk of downward pressure on deposits and EU bank share and bond prices, and thus more liquidity problems for EU banks. If there is any sign of serious banking trouble, the risk of an outright stampede out of EU banks rises exponentially, barring one of the following:
a. Imposition of capital controls as we saw with Cyprus
b. The EU prints money, possible with German assent, as the only short term solution available to save or wind down s bank without causing a contagion fear driven market panic, given the lack of a funded, quickly deployable SRM mechanism to backstop the system.
Second, it's clear from the above that the EU needs to get increase liquidity and availability of affordable credit to the private sector. One way or the other, that means the supply of euros should explode in 2014 and send the EUR down hard, along with any assets tied to it.
See our post here for likely ways that will happen in 2014.
Given the above, that's not the worst risk facing the EU. Is it any wonder that the IMF has recently warned that "1930s-style debt defaults are likely"?
EURUSD Technical Picture
It's worth taking a look at the EURUSD's deteriorating technical picture. The key point is that while major global stock indexes and other risk assets continue to march higher, the EURUSD is struggling to maintain its uptrend.
That may be significant if this divergence between the EURUSD and leading indexes like the S&P 500 continues, because that would suggest that currency traders are recognizing the risks we discussed here and in Part 1. As we discussed here, when currency and stock index trends diverge that can be an advanced warning of coming trend reversals in those stock indexes.
The technical picture for the EURUSD, per its weekly chart below, remains overall bullish, though it we see clear signs of weakening.
EURUSD WEEKLY CHART APRIL 1, 2012 - JANUARY 3, 2014:10 WEEK EMA DARK BLUE, 20 WEEK EMA YELLOW, 50 WEEK EMA RED, 100 WEEK EMA LIGHT BLUE, 200 WEEK EMA VIOLET, DOUBLE BOLLINGER BANDS NORMAL 2 STANDARD DEVIATIONS GREEN, 1 STANDARD DEVIATION ORANGE
· The EURUSD uptrend that began in July 2012 remains intact per the weekly EURUSD chart above.
· The upward slope is strong, with its 10 week exponential moving average (EMA) in dark blue holding as support.
· All EMAs continue to move higher, with the shorter period EMAs layered above the longer period EMAs, a sign of continued upward momentum.
Possible bearish triple top forming around 1.38 with the past week's pullback
EURUSD once again closes the week below its upper Double Bollinger Band Buy Zone (aka DBBBZ, the upper quartile bounded by upper green, orange Bollinger bands). That means as of now there isn't enough upward momentum to justify new EURUSD longs. The EURUSD has spent more time out of the DBBZ than in it since late October, suggesting that upward momentum has stalled. See the 4 RULES FOR USING THE MOST USEFUL TECHNICAL INDICATOR, DOUBLE BOLLINGER BANDS, for a clear, concise explanation of why DBBs are so useful and how to interpret them.
Given the distance to the strong support area carved out last year around 1.33 and then 1.2810, there's a lot of room to profit from just a normal retest of these areas if we can get some confirmation of the trend heading lower.
How To Profit Or Avoid Loss
Given the above, the long term fundamental picture for the EUR is not positive.
Some obvious conclusions include:
· Everyone except short term traders should avoid assets that would be affected by an EU banking crisis that is more likely now than ever. I personally would also avoid short positions at this time, given that timing the next crisis and EUR plunge is impossible until the charts show us it's already starting. Outcomes will depend on a very unpredictable political process in Europe. Recent history shows that when faced with contagion risk they opt for deferring the problem with more borrowing with printed money to those unlikely to pay. Maybe that will continue as long as the bills are relatively small compared to what Germany believes it earns from a strong EU, EUR, and low inflation. However the recent SRM deal allows Germany the option of walking away if the bill for a big bailout is too high for its liking. See here for details.
· For All Long Term Investors Or Traders: If you have long positions in assets with significant EU or EUR exposure, consider reducing or hedging those positions.
· The above is critical for anyone with long positions in the stocks and bonds of GIIPS banks (or anything heavily exposed to them) and keep deposits held in them well below insured limit of about 100k EUR.
· EUR Based Investors: As much as is practical, keep liquid assets outside of EU domiciled institutions and have as much of your portfolio diversified into assets connected to other currencies, particularly those not closely connected to the EU (AUD, NZD, CAD) or in currencies that tend to move opposite the EUR, like the USD. See here for why the USD tends to move in the opposite direction of the EUR.
· Forex Traders
o Short term traders - no changes: Again, in the near term no one knows what will happen, and of course short EURUSD is already a somewhat crowded trade per both COT reports. Per my real time small sample of small retail traders, there is no change, as long positions remain well within their 30%- 50% range of recent months.
o Long term traders: We wait until the EURUSD trend begins reversing before shorting the EURUSD.
The challenges implied above suggest that anyone whose wealth is based mostly in euros needs to know about ways to hedge the risk of EUR debasement. As we've written before, those based in the USD, JPY, and probably the AUD and GBP should be doing the same.
DISCLOSURE /DISCLAIMER: THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY, RESPONSIBILITY FOR ALL TRADING OR INVESTING DECISIONS LIES SOLELY WITH THE READER.