Last week I argued that the "Draghi Put" would prevent the Cyprus crisis from having a material impact on global markets. (Impact Of The 'Draghi Put' On The Cyprus Crisis...). It seemed that the euro (tracked by the Currency Shares euro Trust (NYSEARCA:FXE)) and the bond markets of Spain and Italy were shrugging off the Cyprus crisis. After a week of Cyprus-Troika and Cyprus-Russia negotiations, I want to revisit the euro and see its reaction. Encouragingly, the euro defended a key level and its price action seems bullish on a short/mid term timeframe for three reasons, as discussed below. I will also discuss long term factors for the euro and implications for the S&P 500 (NYSEARCA:SPY) and US markets.
euro At $1.2987 Bullish For Three Reasons
All week I have been watching the $1.29 level for the euro. The $1.26-$1.29 range has been an important demarcation band going back to the beginning of 2012. This band was crossed at important points in the 2012 European crisis and inspired "risk-on/risk-off" behavior by many investors.
On Friday, the euro closed at $1.2987, which was bullish for 3 reasons. The euro stayed above the key $1.29 level, closed above the 200 day moving average of $1.2978 and closed at the highs of the week.
The following 2 year and 1 week charts illustrate these points.
Please note that the Currency Shares euro Trust tracks the movements in the euro, but there are slight differences in the price levels. It is best to look at the levels of the actual euro for trading the FXE.
European Bond Yields
Over the course of the week, yields on the 10 year bonds of Germany, Spain and Italy dropped Furthermore, the Spain-Germany and Spain-Italy spreads compressed, indicating contagion is not being expressed in the bond markets.
The following table shows these bond yields and spreads. It also compares the recent levels to the extreme levels of July 25, 2012, before the "Draghi Put." Please see my article from last week for more about the Draghi Put.
Spain's Bond Yields
The following charts give more detail about the Spanish bond yields. The first chart shows the yield on the Spanish 10 year bond over the last year and the second shows the change in the Spanish yields (orange line) compared to the German yields (green line). Please note that the second chart is not the same as the Spain-Germany spread, rather it shows changes in yield.
Spain's 10 year closed the week below 5%, which is a good sign.
Italy's Bond Yields
These charts show the same for Italy. Italian yields are also below 5%, which is especially encouraging considering the political situation following the recent election.
European Equity Markets
Likewise, the European equity markets shrugged off the Cyprus crisis. After a strong rally following the "Draghi Put" speech in late July, the Cyprus crisis could have been an excuse for the European equity markets to pull back. However, they were mostly flat for the week and the Italian market was especially strong with a 2.3% gain.
The following chart shows the 5-day price action for: iShares MSCI Germany Index Fund (NYSEARCA:EWG), iShares MSCI Italy Index Fund (NYSEARCA:EWI), and iShares MSCI Spain Capped Index Fund (NYSEARCA:EWP) and the SPDR EURO STOXX 50 ETF (NYSEARCA:FEZ).
The euro and the S&P 500
Since the euro crisis of last summer, many investors, including me, have looked at the euro as an indicator of "risk-on, risk-off" sentiment.
For most of this period, the euro and the S&P 500 moved in the same direction and the correlation was highest during the European crisis of last spring. However, over the last month this relationship has broken down.
It will take more time to determine if this divergence lasts. As the global economy and equity markets continue to recover from the 2008/2009 financial crisis, there may not be a strong correlation between these markets going forward. The euro and the S&P 500 may increasingly trade on their own fundamentals as opposed to a global "risk-on/risk-off" trend.
The Euro/USD Long Term
Looking at the long term, the following factors may weaken the euro compared to the US Dollar (NYSEARCA:UUP).
First, the US is growing faster as it emerges from the financial crisis. There are ongoing fiscal headwinds in the US, but the situation is far better than in Europe.
Second, the Federal Reserve is heavily engaged in quantitative easing now and is expanding its balance sheet with $85 per month of asset purchases. I expect these asset purchases to continue for most of 2012 (though maybe at a smaller size late in the year). The ECB has launched its Outright Monetary Transactions (OMT) program but has not yet utilized it. In the coming months, the pace of US money printing may slow, while European money printing picks up.
Third, the ECB still has room to reduce interest rates, but the Federal Reserve cannot lower interest rates any further. Although it is unlikely that the Fed will raise interest rates until 2015, I expect the US to raise interest rates before Europe.
These are potential long term catalysts and may or may not materialize. However, it does raise the question of how much longer will a strong euro will be seen as a positive for the S&P 500 and US equities.
The euro and the European bond markets are shrugging off the Cyprus crisis. As of the time of this writing, it seems that Cyprus is moving closer to accepting a bailout from European institutions, which could be a further catalyst for the euro. The euro's price action last week was positive on three fronts: (1) it stayed above the $1.29 level, which has been important in last year's European crisis, (2) it closed above its 200 day moving average and (3) it closed at the high of the week.
The Cyprus crisis is not yet over and the Cyprus government may not agree to the bailout. Although the euro and European markets have shrugged off the Cyprus crisis so far, they may react differently to a final rejection of the bailout, which could cause Cyprus to leave the euro. Even if the Cyprus bailout is accepted, there is the possibility of a "buy the rumor, sell the news" phenomenon.
Furthermore, Spain and Italy still face many issues and those countries could be catalysts for further European problems at any time. The German election later this year could also shake things up.
Finally, my long term thoughts on the euro may be proven wrong for many reasons, especially the unpredictability of the evolving European situation.
Please note that I have no information about the actual plans of any of the companies mentioned in this article. I do not speak to the executives of these companies and these thoughts are purely my own observations. They may be accurate or not and any of the trends mentioned above could take a very long time to materialize, if at all, so please do your own homework. If you disagree with me, please feel free to comment below.
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