EUR/USD: A Possible Trend Reversal

Includes: FXE, GLD, UDN, UUP
by: Vision Capital M.

The euro got its verbal support during last week's speech of Mr. Draghi, President of the European Central Bank, at the Global Investment Conference in London. He said "ECB is ready to do whatever it takes to preserve the euro,", adding: "believe me, it will be enough." Those remarks sparkled a rally of the euro probably covering a lot of short positions along the way. As a result the euro appreciated against the U.S. dollar with more than 1.5% to finish the week at 1.23.

The big question now is how sustainable this appreciation is. Is there a new trend forming?

When evaluating currencies we should not forget that their values are measured relative to each other. This means that all other things equal, the currency whose economy has less perceived problems should cost more in terms of the other currency.

Until now the euro had enough problems on its own, including sovereign debt ones which resulted in weak economies with high unemployment and social unrest. There was speculation that the euro would collapse as a currency and thus cease to exists. Little attention was paid to the fact that there are no easy legislative procedures for a country of the European Union to leave the Union once she got in there.

Most of the problematic areas of the euro continue to be valid today. What the speech of Mr. Draghi marked however, was the distinctly decisive will of the ECB to act in case of need. Those actions would target mainly the liquidity obstacles in the Euro zone, including high bond yields of some member states.

The ECB has a history of market interventions in order to secure financing in the markets. Since 2008 till June, 2012 the base money in the Euro area increased with 54%. Most of the rise was attributable to the liquidity operations of ECB, including main refinancing operations (MROs), covered bond purchases and longer-term refinancing operations (LTROs), among others. Since the beginning of 2012 the base money increased with about 33% mostly because of the use of LTROs. The money provided by the LTROs during 2012 are almost 2.7 times more than the value for 2011. That is almost the same increase in money supply as the one FED achieved during its two rounds of quantitative easing programs. There is a chance those operations will be further extended if needed.

A Bloomberg article on the next day revealed possible talks with the Bundesbank President Jens Weidmann on the expected bond purchases on behalf of the ECB in order to lower the bond yields of Spain and Italy. Bundesbank has long been opposing such purchases considering them a direct financial help to governments. There are indications though that bond interventions on behalf of the European Financial Stability Facility could be accepted. That alone was enough for the market to lower the yields so they finished the weak below the unsustainable level of above 7%.

The language and consecutive initiatives of Mr. Draghi including the agreements with Germany and France on a political level to protect the euro, made clear he is ready to aggressively defend the existence of the single currency. This does not mean the euro could not fall further. It means it won't just disappear. But how much U.S. dollars would cost an euro at the end of 2012? This depends on a combination of macroeconomic factors and the perceived weaknesses markets see in each of the currencies' economies and political systems.

After a declining euro trend that continued more than a year and depreciated the single currency with almost 20% against the U.S. dollar, we are now beginning to see some cracks in it. Reasons could vary. The compounding effect of positive marks the lower euro has on the stronger ones of the European economies, especially on the exports and industrial production could hardly be ruled out. Another group of factors which are yet to drive the currency values lie in a comparison between future expected events in Europe and the United States. Mr. Draghi's speech was only a spark which caused markets to reassess their current moods.

There are two major events which could weight on the U.S. dollar and have the potential to change the perceived stability equilibrium.

The first one is the U.S. elections in November. With so many elections coincided by time the uncertainty over the future prospects of the country increases. There is a great chance such uncertainty to be disliked by the market participants so the support, and therefore the demand for U.S. dollars would decrease relative to other currencies. This would be the case given the fear over the European liquidity concerns gets off the table for at least a while.

A second, and even maybe a bigger factor could be the possibility of hitting the U.S. debt ceiling again this year. After a prolonged and exhausting debates the debt ceiling was increased last year to $16.394T. Those talks resulted in the first-ever downgrade of the U.S. credit rating made by Standard & Poor's. The agency cited the inability of politicians to agree fast enough on the subject as the chief cause.

As of July 25, 2012 the U.S. public debt subject to the limit amounts to $15.836T. This is 96.6% of the ceiling. Until now, during the current fiscal year the public debt increased with $1.09T which is about 66% of all the difference between the debt at the start of the year and the ceiling. We have 56% of the year passed and there are more public funding to be made given the payroll tax cut was extended to the end of 2012.

Given the coming elections there is a chance the debt ceiling and the fight over additional budget cuts to be used by political parties both ways. This would result in more disruption in the functioning of the country together with the higher possibility of a further downgrade of the credit rating.

The macroeconomic conditions are not particularly strong on both sides. The stronger dollar is basically hurting the exports of the U.S. in the weak international environment it operates. The slowdown of the U.S. economy is visible in the recent GDP data where the annualized U.S. GDP fell to 1.5% in the Q2 (from 2% in Q1). The main reason was a deceleration of personal consumption expenditures.

The inflation differential between the two rivals is neither supportive nor weighting on the value of their currencies. If we take the current overall inflation, the U.S. one drops to 1.68% in June while the E.U. inflation stays at 2.4% for the last two months. This is supportive to the dollar. If we exclude the volatile components of food and energy however, the order changes with the U.S core inflation being at 2.2% and the E.U. one at 1.6%. So the euro should be higher. The food supports the increase of inflation on both sides. The drought and the unfavorable weather could further hurt some of the crops and affect the prices and inflation on a global scale.

The unchanged E.U. inflation combined with better working economies due to the depreciated euro could not allow the ECB to decrease its main refinancing rate at its meeting this week on Thursday, 2 August. This would add another euro supportive factor. Especially if the lower level of U.S. inflation allows the FED to issue some form of QE3 operations. Those however, could hardly be expected before the U.S. elections.

Given the conditions examined above, a change in the downtrend of the euro seems possible. It might still reach the 1.18/1.15 levels in a sudden panic mode but the fundamentals are changing.

A lower dollar would most certainly mean higher gold prices. This is one of the ways to take advantage of the current scenario. A previous article of mine on gold gives some additional reasoning on the probable market supports of gold prices in near term. An investment in gold could be done by using either real gold bullion or an ETF like SPDR Gold Trust (GLD) which tracks the price of the gold bullion. Using the ETF spares the investors the need to pay separately for storage and insurance of their gold and might provide somewhat better liquidity. The expense ratio of GLD is .40%.

The other commodities could also provide value in a weaker dollar environment. While for the food and agricultural items there are favorable fundamental factors as the drought, hot weather and growing world population, a possible increase in the energy prices could be capped by the not-so-bright world growth opportunities.

For the U.S. investors trying to hedge their overseas positions a short position in an ETF like the Deutsche Bank USD Index Bullish fund (UUP) could prove to be an nice option. It has an expense ratio of .50% and tracks the performance of the U.S. dollar against six other major currencies.

Investors who prefer the long side of the deals, could use positions in DB USD Index Bearish (UDN) or CurrencyShares Euro Currency Trust (FXE). UDN is composed of short USDX futures contracts and replicates the performance of being short the U.S. dollar against six other major currencies. It has an expense ratio of 0.50%. FXE tracks the value of the euro against the U.S. dollar and has an expense ratio of 0.40%.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.