After the market carnage the last few days, it's easy to begin to think that the whole world has changed other than prices. If we look back just a week, the last few days gave one the feeling that what was true last week is no longer true. However, the reality is that not much has changed. Here's what we knew at the beginning of last week.
China is slowing.
China's stock market (NYSEARCA:FXI) bubble is bursting.
Commodities like oil (NYSEARCA:USO) and iron ore are in a bear market on less demand from China.
The Fed wants to raise rates this year.
The Fed and the Bank of England are the only central banks where a rate hike has even been mentioned.
The ECB and Bank of Japan continue to print money.
Bank of Canada has cut rates twice this year and will most likely do so again.
U.S. labor market has seen 200k+ average monthly job growth the last two years.
U.S. inflation remains abnormally low.
These are facts that were true last week and remain true now. The events of the last few days are the result of a trading correction and not an economic one. Last week I wrote an article titled "Expect The Second Half Of 2015 To Be Much Different Than The First." I highlighted the trend changes that I saw taking place in the market, including higher gold (NYSEARCA:GLD) prices, stronger euro (NYSEARCA:FXE), and a weaker U.S. dollar (NYSEARCA:UUP). A few weeks ago I even warned yen (NYSE:FXY) bears about pressing the short side.
I'm happy that I foresaw many of these events. The problem is that what I had anticipated occurring over the next few months all took place in a matter of four days. The moves we've seen in the past few days were too extreme. We saw the euro/U.S. dollar go from 1.10 to 1.17. The U.S. dollar/yen go from 124 to 116. The U.S. dollar index dropped from 97 to under 93. These are extreme moves in the currency markets on the absence of any real new economic data. This was a massive unwinding of positions. There were far too many short the euro and the yen and long the U.S. dollar.
The euro is now trading at levels not seen since January. The main reason for this move is that the euro is the new funding currency in the carry trade. Investors are borrowing in euros and buying higher yielding assets. When you have capital flight like we did the last four days, the carry trade positions get closed out. Hence the extreme move we've seen in the euro.
While the Greek crisis was somewhat resolved albeit they kicked the can down the road, Europe's recovery is still anemic and fragile. A higher euro hurts exporters and slows inflation. This is not what the ECB wants. According to Bloomberg, expectations are that the ECB could make attempts to talk down or weaken the euro. I think there is a high probability of this because the euro did not rally on fundamentals. Instead it was the unwinding of the carry trade that sent the euro as high as 1.17.
What's next for investors?
China just cut interest rates hoping to calm the markets. In my opinion, they should have done that over the weekend. If they did, it would have saved everyone a lot of grief and anxiety on Monday. As markets calm down, I expect the euro to drop back down to the 1.12 area and possibly test the 1.10 support level again. Investors that agree with me can buy the ProShares UltraShort euro ETF (NYSEARCA:EUO).
As I've said in my previous articles, I am not as bearish as some on the euro. I am not expecting it to trade at parity with the U.S. dollar and think the lows in the euro are already in place. However, this recent move was far too soon and too fast. That's why I have a bearish view of the euro in the short term. Longer term it will depend on the Fed and what their next move is.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I can and will enter and exit the forex markets at anytime.