Why the ERO is Ready to Rally

Sep.14.08 | About: iPath EUR/USD (ERO)

The ETF that tracks the EURUSD exchange rate (NYSEARCA:ERO), has just bounced off its 52 week low of 51.60, and is currently trading at 54.75. From both a fundamental and technical perspective, it looks like the ERO could be preparing for a rally.

Below are three key pieces of evidence to suggest this may be the case:

1. The Fannie (FNM) / Freddie (FRE) bailout. The decision of the US government to bailout Fannie and Freddie is likely to have enormous consequences for the US dollar over the next few years. While the US dollar strengthened on the announcement (and thus the ERO fell), the fundamentals underlying the US dollar do not justify this; if anything, the dollar has weakened. The US government simply cannot afford this multi-trillion dollar bailout, and thus will need to expand the money supply via the Federal Reserve to pay for this bailout. The expansion of the money supply will invariably result in a devalued US dollar, and while the Eurozone is having its own economic problems, they pale in comparison to devaluation the US dollar is set to experience thanks to the bailout of Fannie and Freddie.

2. FDIC bailouts. Of course, Fannie and Freddie is not the only bailout in town. The FDIC has 117 banks on its watch list, up from 90 at the beginning of the year. The FDIC is already warning that it may need to borrow money from the US Treasury, as its current reserves are below the required amount of 1.15% of the total insured amount. This will likely lead to a need for additional money to be created via the Federal Reserve system, which in turn will further expand the money supply and devalue the US dollar.

3. Technically, a reversal is forming. Since the ERO was born under a year and a half ago, it can be useful to look at the actual EURUSD price action to get a longer-term perspective. The chart below is a monthly chart of the EURUSD for the past eight years. The market tested the strong support line at 1.3850, but promptly bounced off. As this strong trendline is still intact, the technicals suggest the long-term trend is still intact as well.

Click to enlarge

From a fundamental and technical perspective, the ERO seems ready to rally.

Disclosure: none