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, MoodyFX (11 clicks)
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Summary

  • The European and United States economies are at odds.
  • Relative CPI indicates that it is time to sell the euro and buy the dollar.
  • Central bankers actions suggest that it is time to sell the euro and buy the dollar.

The global economic environment is currently divided in the developed world. Presently the United States stands on the cusp of emerging from the longest recession since the Great Depression while European nations are in danger of falling into another recession. In light of this divergence, an excellent investing opportunity exists in the euro (NYSEARCA:FXE) and the dollar (NYSEARCA:UUP).

Measuring the Economy

In this article, I measure the strength of the United States and European economies through the Consumer Price Index. The CPI measures many things, but in general the conclusions I draw from the indicator are that it is a measure of inflation and a proxy for the health of an economy. As the CPI changes (within reason) we can safely say that an economy is heating up or cooling off. Rather than simply examining the flat CPI figure provided by the publicist, I believe that one should look at the relationship between nations. In other words, in order to trade the euro and the dollar, we should factor in both the health and velocity of the eurozone and the United States. In the chart below, I have provided the EUR/USD exchange rate against the relative CPIs of the eurozone and the United States.

(click to enlarge)

The blue bar chart shows the difference in CPIs between the Eurozone and the United States. When the blue line is above the horizontal axis, the European economy is accelerating relative to the United States economy. Conversely, when the blue line is below the horizontal axis, the United States economy is accelerating relative to the Eurozone. Simple enough?

The Relationship

The significant of this chart is that it gives a fundamental barometer for relative currency strength. For example, when the Eurozone is accelerating versus the United States, the economic strength of the Eurozone should attract funds from the United States. This pull of funds should increase the euro against the dollar as dollars are sold for Euros to participate in the warming European economy. A prime example of this relationship can be seen from the beginning of 2012 through the middle of 2013. During this time period, the Eurozone strengthened at a greater pace than the United States pulling funds into Europe resulting in an increase in exchange rate.

The Recommendation

Since the end of 2013, the United States economy has quickened at a greater pace than the European economy. This has led to a pull of funds from Europe into the United States, all else equal. This movement of funds has resulted in a declining in the EUR/USD exchange rate by over 3%. It is my belief that there is significant downside yet to be seen. I believe that the United States economy will continue strengthening against Europe and euro shorts/dollar longs will be rewarded. I have gone back and tested the current economic relationship between Europe and the United States and found that this specific macroeconomic environment has only existed 6 times in the past 5 years. Of these 6 occurrences, the EUR/USD exchange rate proceeded to decline 83% over the quarter following the similarity. In other words: we've been here before and historically it has not looked well for the euro relative to the dollar. I believe this represented an excellent shorting opportunity in FXE and a buying opportunity in UUP.

I believe that this recommendation is strongly supported by the actions of the central bankers. Draghi of the ECB has hinted at both the need of a weaker euro as well as the potential of entering quantitative easing. Each of these factors indicate that the euro is potentially in for a further decline. Also, the Federal Reserve has pointed to an end of simulative action and an increase in the discount rate. This increase serves as a trailing indicator of inflation and economic activity - CPI. These actions are only suggested and taken if the economy strengths. As the economy strengths, the currency tends to strengthen due to an influx of investment capital. In other words: if you desire to not trade against the central bankers, short the euro and buy the dollar.

Source: EUR/USD: The Bottom Has Yet To Be Reached