Another day, another Central Bank meeting that ends in more pillow talk from central bankers, this time from the second mostly widely known Italian with the first name Mario. Saying that expectations were supposedly low going into the meeting would be a massive understatement. First of all, the new covered bond buying program is only a month old and secondly, this is the ECB we’re talking about. As prior history has shown, outside of an existential crisis they prefer to debate rather than to do. As most ECB watchers laid out, the sole determinant of success for this meeting was whether that the Governing Council somehow managed to stay united behind a single objective and leader instead of revolting against Draghi’s management style of making promises and then expecting you to deliver. It’s a pretty darned low bar and investors, including yours truly, might just about be at the breaking point.
Now why should I be so upset by this? I’m a rationale and seemingly educated human being who knows the main job of any central banker is to present the image of a well-meaning bureaucrat who’s monetary measures can help stimulate the economy while actually avoiding doing anything at all until their hands are forced. Using that logic, Draghi and the ECB have done a magnificent job up until this summer, heck even better than the Federal Reserve. From July 10th 2012, the day when Draghi promised to do everything and anything to save the Euro, to say July 10th, 2014 the iShares EMU Index (EZU) rose over 64% while the S&P 500 was up 45% and what makes it truly impressive is that it was entirely a confidence move with no follow-through. Ben Bernanke had to deliver multiple monetary easing operations in an effort to boost the FED balance sheet and instill confidence. Draghi mostly just made promises that the German’s have managed to tie up in various constitutional courts for the last 18 months while the EU balance sheet continues to contract. Pretty darn impressive if you ask me. Draghi might be the real Super Mario.
But since July 11th, 2014, the situation has deteriorated and badly with the S&P 500 up 3.23% while EZU is down 10.44%. What’s holding back the Eurozone and setting it up for long downward deflationary spiral like Japan in the pick-a-decade? Those dastardly Germans of course! Remember, Germany is following one of the most basic economic growth models; restrain wages to increase competitiveness, grow your economy through exports (something to the tune of 50% of GDP) and hope that your citizens never actually start to spend some portion of their savings. Think China with really good domestic beers. Following the economic slowdown that was reunification, Germany updated its model and became a leading proponent of the Eurozone single currency plan for a number of simple reasons:
1. To sell more to their southern neighbors. With a common currency and common monetary policy, the southern EU members could borrow at historically low rates and the common market/currency made German exports more attractive.
2. As the largest economy in the EU, Germany has disproportionate influence on the ECB so there was no real control over German monetary policy being given up.
3. By running a capital account surplus, the Germans have accumulated capital to use as leverage against other EU states. Be good or Germany won’t loosen the purse strings. Remember, they have ALL the money. Yes, that’s a gross understatement but just roll with it.
Those diabolical Germans. I guess the Simpsons had it right after all. And what changed this summer? Yes there’s Vladimir Putin and the prospect for lost sales to Russia, there’s the continuing weakness in the PIIGS as Italy slips into another recession. The Scottish referendum and concerns over the UK departing from the Eurozone didn’t help. But really, what happened is that German growth began to falter as a strong Euro, low unemployment and modest wage growth led Germans to actually begin IMPORTING more than they export to the rest of the world, lowering their current account surplus. The fiends. Of course, that’s exactly what’s supposed to happen when you run a current account surplus (else how are they supposed to get the Euro’s to buy your goods) but don’t tell the Germans. Remember, they’re still afraid of hyperinflation.
So why did I go through all of this? To illustrate a few core concepts that I think are necessary to guide any European trading strategy:
- The chances of the northern states forming a new “Northern” Euro or a return to the DM are zilch. A new DM would skyrocket against a rump Euro made up of the southern states, making German goods incredibly expensive.
- So Germany has the most to gain by continuing the current economic arrangement, hence their intransigence (had to look that one up) within the ECB Governing Council. The concerns over hyperinflation are just a false flag to cover their true motives.
- Germany will try to continue its export-driven policies that have worked for decades and a weaker Euro will appear to be the key to that.
- Given that, it’s likely that the Euro will continue to weaken but survive, with Draghi waiting for another crisis point to force the hand of the ECB council into agreeing with anything he says.
- Germany will try to huff and puff but recognizes that they have the most to lose if a coalition of France, Italy and Spain join to ease monetary and fiscal policy within the EU. You’ve seen Merkel back down before when confronted about austerity measures even to the point of agreeing to “ease” targets and underwrite small business loan schemes. In the event that the UK decides to hold its referendum and leave the EU (since they foot an increasingly large portion of the EU budget, this is likely), Germany will have no choice but to back down.
So where does that leave us? In the worst place of all, with the status quo remaining as it is until another deflation crisis begins.
Short-Term Trade Ideas:
So just to broad stroke some ideas let’s start with a common denominator, Euro weakness. With the common currency seemingly stuck in a very long-term symmetrical triangle pattern, negative investor sentiment and with most Euro institutions and leaders devoted to weakening the currency; it’s hard to find a potential catalyst to push it higher with the possible exception of short Euro positions being back to their July 2012 highs. In fact, if you had shorted the Euro on 7/11/14 or just bought the Proshares Short Euro ETF (EUO) you’d be sitting on a 9.76% gain at this point. But with all the potential for weakness, I’d be hesitant about shorting the Euro for an extended trade.
Start by looking at the daily chart of FXE below. The Euro seems stuck in a downtrend channel and given the amount of pressure it’s under, I’m concerned it would only take a small rally to get a lot of short covering so I’d like to see a failed attempt to breakout around the $125 before going long with EUO.
On a weekly chart, you can see FXE is almost back to the 2012 lows with no more prior support to help prop FXE up before hitting the $120 level. I wouldn’t be surprised if there’s a bounce of some kind at these levels with prior support around $126 acting as a natural resistance point. An even longer-term chart of the last six years shows us in a possible symmetrical triangle pattern and about to hit the lower bound. Without a major negative catalyst, like another German minister talking out of turn about new budget cuts for pick-a-nation, I think a bounce is in order.
What about equities? While we all hold our breaths on whether the ECB will come up with another plan the German’s can object to, if there is a confidence booster in the Eurozone you might see a Euro rally meaning the time to have your European equity positions in dollar hedged ETF’s like the Wisdom Tree Europe Hedged Equity ETF (HEDJ) are numbered. While HEDJ has held in better than EZU since the summer sell-off, during the great 2012-2014 run-up, EZU gained 64.28% while HEDJ was up 40.30%. There are times you want that currency return, even if just temporarily and in this case, it’ll be temporary. We’ve seen a noticeable breakdown in the historically positive correlation between the Euro (here using FXE) and EZU. If equity sentiment improves, there’s a reasonable case to be made it’ll be on the back of a weakened Euro a la Japan in 2014.
But looking at the straight picture without worrying about currencies; while European stocks could be setting up for a momentum turn around against the S&P 500 (probably off annual reallocation’s here at home), it’s hard to see a short-term catalyst to change the picture. On a daily basis, EZU looks to be losing steam after today’s as-expected ECB press conference without challenging either the down-trend line around $37.50 let alone overhead resistance at $38 while hedged HEDJ gained .89% on the day.
For my two cents; I’d wait for FXE to bottom out and make signals like it’s ready for a push higher. If FXE blows through $125, close out a short Euro, long HEDJ trade and be ready to plow back into good ole EZU if FXE can find the energy to get back above $126 and stay there. If it fails, it’s reasonable to assume FXE will then be retesting $120 and there’s no reason to hold long unhedged equity positions or currency exposure for that pain trade. But if we do get back about $126, it’d also be reasonable to assume there’s a confidence booster of some kind at play and unhedged equity exposure via EZU could be just the ticket.