Bullish and Bearish: Forced Neutrality on the Dollar

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Includes: ERO, FXE, UDN, UUP
by: Douglas Borthwick

Last week's move lower in the EUR/USD stopped us out of our weaker USD story, as our trailing stop took us out on the Friday after Thanksgiving. On the whole we fundamentally remain of the view that the USD must weaken from here. It is not a popular view, yet one that we have been fighting and winning for much of the year. Last week’s price action allows us to look again at what moves the USD so that we may better define what to look for going forward. We look at the EUR/USD from the view of the Bull and the Bear; and we discuss specific actions and indicators. Charts are found at the end of the discussion.

On the whole we fundamentally remain of the view that the USD must weaken from here. It is not a popular view, yet one that we have been fighting and winning for much of the year. Last week’s price action allows us to look again at what moves the USD so that we may better define what to look for going forward. We look at the EUR/USD from the view of the Bull and the Bear; and we discuss specific actions and indicators. Charts are found at the end of the discussion.

The 2-Year Swap Spread (Chart 1)

EUR/USD Bear

The 2-Year Swap Spread differential moved lower from 110bps on November 2nd, 2010 to 82bps today. The spread tells us while at the start of the month you would have received 110 bps more investing in European debt, you now only receive 82 bps. Thus European debt is less attractive, and so people are moving their assets out of Europe and into the US. This is EUR/USD bearish.

EUR/USD Bull:

Certainly the yield differential has moved lower, but let's look at the reason why. US rates have jumped from .47% on November 2nd, 2010 to .78% today. US Yields in the 2 Year tenor have rallied 30 bps despite the Federal Reserve buying the curve. This tells us there is less demand for US paper. Over the same period European rates have held steady around 1.6%. As an extreme example, if I told you rates were rising in Ireland, would you invest in Ireland? No, rates are rallying in Ireland because people need to be paid more to hold Irish paper; they see the risk is higher and so they demand higher interest rates. I would argue that rates are higher in the US because investors are demanding higher yields for US risk, and this is EUR/USD bullish.

(Click charts to enlarge)

Yield Spreads

Economic Data

EUR/USD Bear

US rates are rallying because of all the good economic data coming out of the US over the past month. ISM Non-Manufacturing 54.3 vs 53.5 expected; Factory Orders +2.1% vs +1.6% expected; Non-Farm Productivity +1.9% vs +1.0% expected; Non-Farm Payrolls +457K vs +442K expected; Private Payrolls +159K vs +60K expected; Trade Balance -44 Bio vs -45 Bio expected; Michigan Confidence 69.3 vs 69.0 expected; Philly Fed 22.5 vs 5.0 expected; Personal Consumption +2.8% vs +2.5% expected, Richmond Fed +9 vs +6 expected, another Michigan Confidence 71.6 vs 69.5 expected. The numbers all are looking much better, prompting a sell-off in US fixed income.

EUR/USD Bull:

US rates are rallying despite almost daily FED purchases and worse than expected economic data in the numbers that matter to the FED. Pending Home Sales -1.8% vs +3.0% expected; Import Price Index +0.9% vs +1.2% expected; Empire Manufacturing -11.14 vs +14.00 expected; Core PPI -0.6% vs +0.1% expected; Industrial Production 0.0% vs +0.3% expected; Core CPI +0.0% vs +0.1% expected; Housing Starts 519K vs 598K expected; Building Permits 550K vs 568K expected; Housing Starts -11.7% M/M vs -2.0% expected; Existing Home Sales 4.43Mio vs 4.48M expected; Durable Goods Orders -3.3% vs +0.1% expected; House Price Index -0.7% vs 0.0% expected and New Home Sales +283K vs +312K expected. The FED and the US government are looking for 2% inflation and a turnaround in Housing, and they are getting neither. Housing continues in a free-fall, and deflation continues to look likely.

Ireland, Portugal and Spain (Chart 2)

EUR/USD Bear

The CDS are blowing out in Europe, as the market chases each country into either default or a rescue plan cobbled together by the European Union and the IMF. Germany is less likely to approve of further bailouts for Portugal, and Spanish banks are in a terrible mess, with an obscene amount of bad loans on their books not yet written down.

EUR/USD Bull:

The CDS in peripheral Europe are by and large a screen quote rather than a price. They are very illiquid and do not take much volume to push them out. Ireland makes up 1.75% of the Euro-zone's GDP. While the CDS have moved higher, the European 2 Year Swap rate has remained unchanged at 1.6% through the month. While the market has been focusing on Peripheral European CDS, the CDS have also been moving higher for US States. California's 5Yr CDS has moved from around 250 at the start of the month to around 295 today, and The State of Illinois has traded between 270 and 300. California makes up 13% of the US GDP, and Illinois 4.5%. I know that Europe will end up bailing out countries as they need it, but with the Tea Party in a locked Congress who will bail out all the states and municipalities facing budget gaps across the US? The argument that US states have never defaulted is incorrect. Arkansas defaulted in 1933.

US and European CDS

France, Germany and the EUR/USD

EUR/USD Bear:

It is in Germany's and France's interest that the EUR/USD is weaker. It is in both their interest for the time being to highlight irresponsible peripheral countries, given the attention Chancellor Angela Merkel and President Nicolas Sarkozy can focus on them results in a sell-off in the EUR/USD. When they criticize Ireland and Portugal, they are criticizing countries that make up 3.66% of the Euro-Zone's GDP, while France and Germany contribute 49% of the area's GDP. The GDP in Germany and France are both dependent on exports, and a lower EUR/USD helps them immensely.

EUR/USD Bull:

Certainly that is true, but we do know that neither the FED, nor the PBOC are happy with the move lower in the EUR/USD. A higher EUR/USD is needed for a lower USD/CNY to commence. The FED has been buying fixed income daily to result in lower US interest rates with the aim of higher asset prices, inflation and as a consequence a weaker USD; so that the US can export its way forward. President Obama has stipulated his number one administration priority is to double US exports in 5 years. We need a weaker USD to carry this out. The US and China made a 'Grand Bargain' at the G20 regarding USD weakness and CNY strength. It's looking like Europe was to take the pain through a higher EUR/USD and for some reason they weren't included in the US/China discussions.

Is the 'Grand Bargain' dead in the water?

EUR/USD Bear:

For as long as Europe fails to deal with its problems, pressure will persist to the downside. If the 'Grand Bargain' needs a higher EUR/USD it won't happen until bailouts have occurred across Europe, with Portugal next and then Spain.

EUR/USD Bull:

It is not dead in the water. It has been roiled by the comments that came from Chancellor Merkel right after the G20, a time when Merkel saw the EUR/USD was above 1.41 and noted the FED was entering into its second round of quantitative easing. Her comments were very direct in getting the markets to focus on periphery problems. She only let up when German banks explained to her that they had considerable exposure to Ireland. By then though, the EUR/USD had momentum. It took last Friday's price action for Merkel to be pressured into calling for a higher EUR/USD, stating "Germany wants a strong EUR/USD" and adding Germany is "ready to show solidarity on Euro." We think Germany realizes it may have gone too far. While the lower EUR/USD is good for Germany's exports, the questions that arise from a weaker EUR/USD could result in more lasting problems for the European financial sector. We know that Germany has had enough of the EUR/USD weakness, and that the FED seeks a weaker USD through QE2, and that China wants a higher EUR/USD so that they can strengthen the CNY against the USD. With the three largest governments looking for a weaker USD we think it unlikely the USD can strengthen much more.

Where are Asian Central Banks?

EUR/USD Bear:

Asian Central Banks have replaced their daily EUR/USD purchases with daily USD/Asia selling. They have been selling the USD against their own currencies to lower volatility caused by the North Korean shelling incident last week. When the Bank of Korea can sell the USD against the Won at higher prices than they bought last week, then they do so. Only last week the BOK was talking about KRW strength, and now that there is KRW weakness they have halted the move in its tracks. Asian Central Banks continue to sell USD only now against their own currencies.

EUR/USD Bull:

Asian Central Banks will return to the market and buy EUR/USD as soon as Korean tensions ease. The North Korean incident took Central Bankers' minds off reserve currency diversification on fears of unrest in Asia. Talks between China and North Korea will likely settle the issue. It is in North Korea's interest to rattle sabers every few months. This is most likely one of those events.

Technical Analysis (Chart 3)

EUR/USD Bear:

The chart going back to the low in early June shows support has been broken in the EUR/USD, while the 50% retracement level at 1.3091 remains in play.

EUR/USD Bull:

We look at the EUR/USD chart only back to June 21, when China allowed flexibility in the USD/CNY. On that basis the support line remains intact, coming in at 1.3190. The 50% retracement level, from 1.2190 to 1.4282 comes in at 1.3236, so we are right around that level now, while the 200 day moving average provides support at 1.3133. As long as 1.3133 remains intact we like the EUR/USD moving higher.

EUR/USD Technical Analysis



Disclosure: No positions