EUR/USD: Stuck between a European Rock and a US Hard Place!

A couple of blurbs from the past to set the tone! On June 8, 2010 I commented – “Viewed in the context of “risk on / risk off” paradigm, the future direction of this eminently liquid pair will be based wholly on the steps taken to address the global inefficiencies that have built up over the past few decades. The US approach, to try and foster growth by stimulating the economy in the hopes that the resulting stability will ultimately generate higher tax revenues that can then be used to reduce the burgeoning debt, is in stark contrast to the one being adopted by the EU, who seem more intent on reducing their deficits and thus potentially exacerbating the deflationary spiral that is evident. While in a normal functioning economic system, the more fiscally responsible method of controlling deficits etc.. is to be applauded, one has to be cognizant of the fact that these are NOT normal times. The market is aware of this and the EURO is bearing the brunt of its collective verdict.(Euro was around 1.21 at the time of this post)

. On July 14, 2010 I wrote – “Euro is bid as the market is in the throes of correcting its extremely bearish positioning and the risk is still to the 1.30′s. That is where the re-evaluation of the global scenario should take place again and where the market should revert back to the bearish camp later on this year (right now I would put the odds of this at 60/40). BUT it’s a fluid situation right now as market forces continue the process of re-thinking the risk potential that could arise from the differing strategies adopted by the US and Europe in dealing with the global financial crisis. The extreme Euro-zone bearish view that was in vogue a few weeks ago seems to have been tempered by the recent spate of weaker than expected US data. The FOMC minutes, released today, would seem to corroborate this view. Factor in that it is earnings season for US equities and you have an atmosphere that is ripe for further dollar weakness that has to be, for now, still viewed as a correction.(Euro was around 1.27 at the time of this post).

So, what can we expect as the EUR/USD hovers around the 1.28 level? In the past few sessions the Euro has made two attempts to breach the 1.30 level but has so far been thwarted. (As I write, Bernanke is commenting on the state of the economy and dollar has strengthened against all majors, except USD/JPY). Well the simple answer is that the combination of not-as-worse-as-expected data from Europe, worse-than-expected data from the US, and a rebalancing of the extreme bearish posture fueled the EUR/USD rally to 1.30. With the results of the European stress tests looming, and Bernankes’ decidedly tepid view of the US economic recovery prospects acting as a catalyst, the market has quickly switched to risk-off mode as it waits for more evidence before embarking on its next move.

European snapshot! Given the relative lack of drama following the recent debt auctions in Greece and Spain, it would appear that the liquidity crisis that was threatening Europe has been averted for now. The markets’ collective focus now shifts to the results of the bank stress tests that are slated for release this Friday. The ECB, though initially hesitant, has been quite aggressive in providing liquidity. While this did manage to allay market jitters, the inevitable unwinding which has already begun, brings the individual bank balance sheets back into the spotlight. Are we to believe that the European banks are in better shape than the US banks were when they had their hour of reckoning? Anecdotal evidence suggests that European banks might actually have more toxic assets on their books than did their US colleagues. 

What about the other side of this equation, namely the US economic situation? It is widely accepted now that the stabilization of the economic climate was largely due to the massive fiscal stimulus packages enacted by the government. The authorities have done all they could to try and prop up the consumer and, by proxy, the economy. There is, of course, going to be a cost for adopting this policy but, given that the alternative was to get mired in a vicious deflationary spiral, one could argue that they had no choice. This type of aid is likely over as a combination of spiraling deficits and the upcoming mid-term elections should bring some semblance of fiscal austerity back into focus. The troubling aspect is that the US consumer, arguably the backbone of global consumption, has not reverted back to the pre-crisis levels and this has been borne out by the anemic economic statistics that have been coming out recently. This has put US monetary policy on hold for the foreseeable future. Bernanke just confirmed this in his comments as he confessed that the economic outlook is “unusually uncertain” and reiterated the need for exceptionally low rates.

Time to venture out onto thin ice (because everyone’s doing it)- Predicting markets! The global economy appears to be stuck between a rock and a hard place! The different policies adopted by the US and the Euro-zone are both rife with risk. A look at the EUR/USD chart illustrates the “battle” that is being waged in the markets.
1) IF the US economy picks up steam in the next few months (at this juncture that looks unlikely), -or- if global RISK AVERSION comes back with a vengeance (this looks more likely and the YEN crosses would be the barometer of this), then the dollar should appreciate vs. the Euro. The Euro’s bullish move for the past 6 weeks would be viewed as a correction and new lows would be expected on a multi-week basis with 1.15 being a realistic target.
2) IF the US economy languishes AND the Euro-zones’ fiscally austere policies are viewed by the market as being the more prudent course of action, then the Euro has the potential to target the 1.38-1.40 level in the upcoming weeks.
3) IF there is not a definitive outcome and the positioning “battle” continues to rage on, then expect the pair to be range bound probably between 1.25-1.35
Either way, it looks like the US consumer will once again be the ultimate arbiter in shaping the course of the global economy and as of right now, their wallets are firmly tucked away!
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