The EUR/USD exchange rate is the price at which the world demand for US Dollars equals the world supply of Euros. As of July 26, 06:00 GMT, the pair was trading at 1.2146/47. After three days of solid risk aversion (helping the Dollar while weighing the Euro), there was finally a break in the storm.
While the 1.2148 mark is significant as it represents the 50% Fibonacci expansion from the June 29 swing high, we believe that there is a strong possibility of a reversal in prices from the 1.20 level, supported by fundamental factors. We expect the 1.20 level to hold for the rest of 2012.
Deteriorating Fundamentals in the Eurozone
We're into the third year of the European sovereign debt crisis. We've seen bailouts for Greece, Ireland, Portugal and Cyprus. Moreover, various other hard decisions and strong actions in attempting to stem the crisis were also undertaken recently by the EU leaders. As a result, we're seeing the effect play out directly in the currency markets.
Contagion has finally hit Spain, the fourth largest economy in the Eurozone and bigger than all the bailout countries combined. EU leaders are providing a 100 billion Euro aid package to recapitalize Spain's banking system in an attempt to avoid a full blown sovereign meltdown.
If conditions deteriorate, the third largest monetary union partner, Italy, could soon follow and put the very existence of the Eurozone in jeopardy. To combat this, the European Central Bank (ECB) has slashed interest rates three times to a record low 0.75%. They've given European banks access to three-year loans at bargain basement rates; the take-up totaled over 1 trillion Euros.
The recent actions have resulted in a ballooning balance sheet that is now bigger than the Fed's and has also sent the EUR/USD currency to fresh two-year lows.
Stronger Dollar: A Headwind for US Multinationals
The stronger dollar is becoming a headwind and is negatively affecting overall profitability of the US based companies with multinational sales exposure. Multinational drug maker Johnson & Johnson (JNJ) reported earnings on Tuesday. Their second quarter revenue declined and management reduced full year earnings guidance. One of the major reasons cited was because of recent currency trends.
International Business Machines Corp. (IBM)'s Senior Vice President and Chief Financial Officer Mark Loughridge said in a conference call last week after earnings, "Currency in the second half is going to be a headwind, about four to five points in the third quarter, two to three points in the fourth and that spot rates that would be a headwind for us, about $2 billion in the second half compared to the $1 billion that we just had in the second quarter."
Weaker Euro: A Tailwind for European Multinationals
While a stronger Dollar is going to hurt the profitability of US based multinationals, a devaluing Euro should be a huge tailwind for European blue-chip multinational companies. Longer term value oriented investors are now looking to have some exposure into this space and finally taking some long positions in the SPDR Euro Stoxx 50 ETF (FEZ).
Technical Picture: EUR/USD Equilibrium Near 1.20
A short-term equilibrium in the exchange rate for the US Dollar and Euro is expected to set in at 1.2004, the 61.8% Fibonacci expansion from the June 29 swing high. Currently, prices are retesting the 50% Fibonacci expansion at 1.2148. A clear break out above these boundaries exposes the 1.2290-2335 area marked by the 38.2% Fibonacci retracement and the May 31 low.
Investing in the PowerShares DB US Dollar Bearish Fund (UDN) may not be a bad idea at this point of time. The ETF is composed solely of short USDX futures contracts. The USDX futures contract is designed to replicate the performance of being short the US Dollar against the following currencies: Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.