Don't Be Fooled By Euro Gains, Look For Long-Run Euro Weakness

| About: CurrencyShares Euro (FXE)


If investing in Europe: The European Central Bank will likely erode your rate of return.

Expect negative interest rates and anemic growth for the coming months.

The euro exchange rate is a great indicator for capital flows leaving Europe.

The euro spiked last week and broke above the July monthly high, (see chart), which is a very bullish signal in the short run. Be careful, however, because any gains are likely to be eroded in the longer term.

For investors who are long euro ETFs like FXE (CurrencyShares Euro Trust ETF), a euro bounce is a welcome respite but it's unlikely to last.

The key reason for the negative outlook on the euro and the Eurozone's economy rests with The European Central Bank's (ECB) quantitative easing (QE) policy of negative interest rates. The ECB's QE is bad news for U.S. investors who are long securities in Europe since capital flows will likely flee in favor of higher-yielding investments elsewhere.

And it appears low-to-negative interest rates for Europe are here to stay, following the statement from ECB President Mario Draghi who reiterated his commitment to quantitative easing.

"Based on our regular economic and monetary analyses, we decided to keep the key ECB interest rates unchanged. We continue to expect them to remain at present or lower levels for an extended period of time." - ECB press statement on July 21, 2016.

The QE program consists of the ECB purchasing euro 10-year bonds. The result is rising bond prices and falling bond yields, creating negative yields. In addition, the ECB has lowered its benchmark rate it lends banks to below zero. To put it another way, the ECB is charging banks who hoard cash.

Negative rates, in theory, encourage consumers to spend rather than save, as well as encourage banks to lend out their money rather than keeping cash on their balance sheets.

Click to enlarge

The chart from the ECB website shows interest rates fell into negative territory this year for the first time. And since negative rates typically encourage capital flight from the region, investors' assets in Europe are at risk.

If you want to see the impact of the ECB's QE on European capital flows, all you have to do is look at the euro vs. U.S. dollar.

Following the start of QE, the euro depreciated almost 30% before recovering to current levels.

To put it another way, don't fight the trend. If the ECB wants negative rates for the foreseeable future, invest accordingly.

Key drivers for euro weakness:

- Low inflation: Currently stands at .2%.

"Looking ahead, on the basis of current futures prices for oil, inflation rates are likely to remain very low in the next few months." - ECB press statement on July 21, 2016.

- Weak growth: GDP growth for Europe recently posted a .3% gain.

- Uncertainty: Brexit fallout has yet to materialize since it's only been a month since the referendum. Also, the stability of European banks remains in question and it's likely we'll see this topic develop further over the coming months.

"At the same time, headwinds to the economic recovery in the euro area include the outcome of the UK referendum and other geopolitical uncertainties." - ECB press statement on July 21, 2016.

With weak growth, low inflation and economic uncertainty, it's unlikely we'll see any change in direction from the ECB's negative interest rate policy.

If you're long the euro or considering a long position, the medium-to-long term outlook is weak, as additional capital outflows are likely, and uncertainty is here to stay.

Disclosure: I/we 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.