The Euro Rallies As Europe Awakens To A New Era

Includes: CNY, FXB, FXE, UDN, UUP
by: Douglas Borthwick

Last night's late summit conclusion has displayed to the world Europe's dedication to reform. The last few weeks have forced leaders across the eurozone to confront the issues that have led to euro unease. These meetings have oftentimes been heated as leaders have been forced to stop dancing around issues and instead cut to the heart of the matter. When standing at the edge of the abyss Europe acted in a concerted way. We see this as an historic occasion, and the first of many steps to bring Europe together under a European Fiscal Union by 2020.

Italy, France, Spain and Greece are now moving to reduce spending and bring fiscal austerity to their economies. They are being cajoled into doing so by the Germany and the EFSF. If they want to be eligible for funds from this facility, they must play by the rules. In some countries this means raising the retirement age, in all it means a reduction in spending and the privatization of state assets. We note that Europe has acknowledged its problems and is working to reduce them while the U.S. continues to dither on fiscal sustainability.

The market is now thirsting for the meat that is needed to cover the bones of the agreements set forth overnight. Italy has promised reforms, whether they will come into fruition is another matter. We believe they will, but will cost Italian Prime Minister Berlusconi his job. The market is also looking to see whether China will in fact invest through the IMF in the SPIV, as hoped for by French President Sarkozy. We believe they will, however some in the market still question whether the U.S. will allow the IMF to facilitate this transaction. Given the U.S. administration's need to allow the CNY to strengthen, and our view that the CNY can only strengthen against the U.S. dollar if the EUR/USD rallies, then we see this as not being an impediment.

Much of the market remains negative on Europe's future, and have a married, emotional commitment to sell the rally in the EUR/USD on any opportunity. We believe this will help fuel the EUR/USD above 1.4500. There are a number of flows to be aware of that will come back into the market.

This morning model funds began to flip out of EUR/USD and AUD/USD short positions. Models act without emotion, and are not married to ideas or fundamentals. Rather they trade for the most part on moving averages, and today the EUR/USD, AUD/USD and the USD/Index are all trading through their 200-day moving averages. Momentum is on the side of the USD-short.

We believe that the recycling of USDs into the euro from Asian Central Banks will come back to the market, as they each seek to manage the new-found appreciation of their currencies and ensure that they do not allow their currencies to appreciate too much relative to their peers. We expect to hear of Asian Central Bank USD buying against their currencies in the Asian time zone, and then the buying of SDR currencies such as EUR and GBP in the London time zone as they diversify out of the USDs they bought in Asia.

We expect to see continued repatriation of capital by French, Spanish and German banks as they seek to bolster their balance sheets ahead of recapitalization plans with a deadline of June 2012, and finally we expect to see EUR/USD buying come from Asian and Middle Eastern reserve managers as they buy the euro to purchase investments in EFSF bonds.

While we note that Europe has come up with a solution to deal with the short-term fiscal issues, we agree that longer-term fiscal issues remain. However when looking at the EUR/USD there are two parties: Europe and the U.S. We argue that while Europe is dealing with its fiscal issues, we have yet to hear from the "Super Committee" set up by the U.S. congress to find ways to decrease spending in the longer term. We are growing concerned by the lack of action from this committee, and believe rating agencies will begin commenting on the U.S.'s lack of action since the last downgrade. While the market is focusing on the credit rating that will be attained by the EFSF, we believe that it is the U.S. rating that may get more attention going forward.

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