European Summer Of Discontent Starting Early, Pressuring The Euro

Includes: FXE, FXY, UDN, UUP
by: Ralph Shell

Markets are continuing the assimilate the consequences of the recent elections, and the wall of worry confronting investors has not diminished. France has elected the new anti-austerity socialist expected to do battle with Chancellor Merkel, no doubt hoping the frugal Germans will loosen the purse strings. Or if not the Germans directly, maybe Draghi and the boys at the ECB in Frankfurt can buy some more poor quality sovereign debt. Yes and maybe the ECB can become truly the lender of last resort, and perhaps issue some euro bonds.

The chances are the Germans are not going to endorse such a program, and even if they did, the market would stop financing the big spenders.

As has been pointed out in an IBD Editorial, most European nations have yet to try austerity. Greece, Ireland and Portugal are the exception but most EU nations have increased their spending since 2008. Further, IBD claims:

"During the 2000's, EU member nations collectively boosted government outlays by 62%. Average government spending by EU nations today stands at 49.2% of GDP versus 44.8% in 2000."

The French government's share of the GDP has increased to well over 50%, and the new guy Hollande is going to stimulate growth by hiring more civil servants and teachers? Really? We know from experience, when the government takes an ever expanding share of the GDP, an economy will not grow.

Lost in the aftermath of the weekend elections was an announcement from Madrid that the government will need to inject capital into ailing Spanish banks that have bad real estate loans. This prompted a sell off in the Spanish banks, and has taken the IBEX35 Index down over 3% today. The bench market 10-year Spanish bond is now yielding 6.04%.

U.S. Treasuries appear to be benefiting from a flight to perceived quality. Yesterday the Treasury sold $32B three-year notes at a yield of 0.362 and a bid to cover ratio of 3.65. Results on today's 10-year are not yet in.

Equity markets continued to be under pressure as the NY session opened, following the European markets. As we suspected, this has resulted in further weakness of the EUR/USD, gradually chewing through the support under the 1.30 handle. Again the open interest in the CME futures market increased yesterday, up 8,771 contracts as bears add to positions.

We have no way of knowing if the support under the 1.30 area perhaps from the Chinese or central banks will vanish leaving the euro to fall further. If the support remains in place and the euro can shrug off the bear news, perhaps the recent buying in the yen will likewise end. The .y.en has been on a lengthy rally versus the U.S. dollar. We will be looking to establish a long US dollar short yen position once the markets calm. But best be real careful, because the trading track is fast and slippery.

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