Why The French And Greek Elections Are Bearish For The Euro

Includes: EU, FXE
by: Labutes IR

In view of the ongoing European sovereign crisis, the single currency (euro) has shown a great resilience against the USD. Over the last few months, the EUR/USD cross has been trading on a narrow trading range between 1.30-1.35, during a period in which Greece has defaulted and the ECB massively expanded its balance sheet through its LTRO operations.

Much of this euro strength is explained by the ECB's LTROs, which on its two refinancing operations lent nearly €1trillion to European banks which in turn bought sovereign and corporate bonds, resulting in a huge decline in bond yields across Europe.

This was especially evident for peripheral countries like Portugal, Spain, Italy or Ireland. This led to a false sense of security that the crisis was over, bidding up the euro. The recent pressure on Spanish yields is evident that the crisis continues and should continue to negatively impact the euro.

Source: YahooFinance

Although the last month's developments could suggest that the European crisis is restricted to the weaker countries, the single currency remains with its structural faults. The most obvious are the differences in language, culture and economic power within euro zone countries that make the joint currency much more a political than economical one.

Europe's politicians continue to not deal with this, failing to reach a political solution to the current crisis. As I discussed in my previous article "Europe Needs To Work Toward Fiscal Union", this will, in my viewpoint, require much more political integration and ultimately a fiscal union.

This weekend's elections in France and Greece, where the ruling parties lost the elections, clearly shows that European people are tired of austerity measures. These elections can represent a withdrawal from austerity to more growth-driven policies, which are more populist and the easiest route to politicians to go. Obviously, this has a price that is more fiscal relaxation, something that Germany strongly disagrees with.

François Hollande said he wants to revise the fiscal compact which is not even yet ratified, leaving Merkel politically isolated. If France and Greece reject austerity, how long will the German public support the union and the euro and how long until they demand a return to the deutsch mark? This will exacerbate political tension in Europe and be very negative for the euro.

As a political currency, if the political leaders start to disagree on the road to recovery, this increases a euro breakup scenario, something that can happen over the next weeks. The recent strength of the euro can be called into question over the short to medium-term, possibly leading to testing the lows reached at the beginning of the crisis in 2010 (around 1.20).

Additionally, the Netherlands government coalition parties don't agree on austerity measures and the odds of a Spanish bailout are increasing. If Italy also goes on the same path it's obvious that the ESM/EFSF rescue programs won't work, putting in jeopardy the steps taken since the beginning of the crisis. This will be obviously extremely bearish for the euro and this weekend's elections could be the trigger for that to happen.

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