The Concern Over The U.S. Stock Market And The Strength Of The Euro Have The Same Cause

Includes: FXE, UDN, UUP
by: John M. Mason


Euro continues to exhibit strength against the US dollar.

Europe, following Germany, is facing disinflation or even deflation, whereas the United States is not.

The monetary policy of the Federal Reserve has helped to create the Euro situation as well as inflate US stock prices.

In the middle of December, I wrote about the strength of the Euro and that fact that Germany seemed to be winning the economic battle. At that time, the Euro had reached the recent high of $1.3768.

This week, the value of the Euro jumped up to a little more than $1.3900. And, at this level, the Euro was at its strongest against the dollar since the end of 2011.

Mario Draghi, the President of the European Central Bank (ECB) responded to this strength by saying the ECB "forward guidance" on interest rates would provide downward pressure on the euro.

For the time being, the value of the euro dropped off modestly.

But, the pressure for a higher value for the euro remains.

For one, the threat of deflation is still high on the list of concerns about the European continent. Ralph Atkins and Delphine Strauss write in the Financial Times that "inflation" in the eurozone "was projected to remain well below the target annual rate of 'below or close' to 2 percent until 2016." Others have made a more dismal projection.

Officials in the eurozone have not been able to escape the pressure Germany has constantly applied in recent years to maintain a stable economic posture and keep the pressure on for the peripheral countries to reform their economies and become more productive. German Chancellor Angela Merkel has been relentless in this pursuit.

And, this has been exactly the opposite of what President Obama and the officials at the Board of Governors of the Federal Reserve System have been promoting.

Atkins and Strauss write "the Euro's continuing strength has reflected the current account surpluses run by eurozone countries and the increasing investor confidence that the eurozone debt crisis is over. As investors fled emerging markets and with US equities looking expensive, the strengthening currency became an additional attraction."

They add that another contributing factor to the current strength of the euro has been "worries about a possible war over Russia's incursion into Ukraine's Crimea peninsula." In effect, the euro has looked like a safe haven.

One currency strategist, Valentin Marinov of Citigroup is quoted as saying "People aren't hedging (currency risks) at the moment when they buy European assets."

And, the Federal Reserve continues to pump funds into the banking system. Even though the Fed is "tapering" its purchases, it still added $75 billion in funds to the banking system in January, $65 billion in funds in February and will add about $180 billion more funds into the banking system if it continues to reduce purchases by $10 billion a month until it is down to zero.

Atkins and Strauss write that "even if interest rates are held stable, the ECB's balance sheet is shrinking as banks repay loans taken out at the height of the eurozone crisis. The US Federal Reserve is still engaged in asset purchases even if the pace is slowing."

In other words, the economic policies of the ECB and the eurozone are less "inflationary" than are the economic policies of the Federal Reserve and the United States government.

By "inflationary" in this context I am speaking more in terms of "credit inflation" than outright price inflation because the funds that are being pumped into the financial system in the United States have tended to stay in the financial circuits of the economy and have not spilled over into the productive circuits of the economy.

The environment of credit inflation in the United States is, therefore, not playing well against the disinflation or possible deflation in the eurozone when it comes to the value of the euro in terms of the US dollar.

But, it's the environment of credit inflation in the United States that has pumped up stock prices and other asset prices as I have just written.

The evidence of these asset markets, to me, confirms my view that the economic policies of the Federal Reserve and the US government has been "inflationary" but in asset prices and not in flow or consumption prices.

The reason for this is that over the past fifty years or so, the most sophisticated investors have learned that they can make lots and lots of money "betting" on the consequences of economic policies of the Federal Reserve and the US government. Look at all the articles over the past week or two reporting the huge profits made by hedge funds and private equity groups.

We even have the report, cited in the post just mentioned, that Stephen Schwarzman, chairman of Blackstone Group, took the time at a recent conference, to thank Ben Bernanke, former chairman of the Board of Governors of the Federal Reserve System, for what he and the Fed had done for the hedge funds and private equity groups.

Stock prices have been so high, in my estimation, because of the largess of the Federal Reserve and the value of the euro has been as strong as it has because of the relative efforts on the economic front of eurozone governments and the United States government. To me these results are just the consequences of how the investment community judges these governmental efforts.

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.