For the growing number of share traders now exploring the FX market, the similarities when comparing the Eurozone and a large corporate conglomerate are striking. Negotiating internal politics, managing debt, and policy making are where the likenesses begin, but it extends deeper. With so much encompassing the make up of this expansive region it is critical to prioritise the factors that will have the greatest impact when evaluating its currency and making an informed prediction on where it will go next. So what are these factors and how do you weigh them up against each other?
The unquestionable CEO of the Eurozone – who also runs its most profitable division – is German Chancellor Angela Merkel. Her outspoken second in command is French President Nicolas Sarkozy. As a potential investor in the Euro versus the US Dollar, having Merkel at the top can only be a check mark in the “pros” category. Her no-nonsense attitude and courage under fire inspire confidence. So too does her impressively strong finger on the pulse of the push-and-pull economic factors affecting not only her own country but the entire region. An investor in any asset wants to look at the top and see a combination of intelligence, prudence, and conviction. The Eurozone and its currency have that in Merkel, despite any dips in popularity she has to ride through on the home front. Being at the helm at a time when your country is posting a two decade low unemployment rate always helps a short-term drop in the approval polls.
Debt Laden Divisions – Greece, Ireland, Spain, Italy, Portugal
Unfortunately, the Eurozone can’t just have a Board of Directors meeting to propose shutting down its laggard countries weighed down by high interest debt. Or can they? The EU Economic Council Meeting the weekend of March 11th seemed a few steps removed from just that. It is fitting that Spain’s credit rating was downgraded by Moody’s to Aa2 the day before the meetings commenced. This just days after Greece’s credit rating was cut three notches. We saw in 2010 the Euro take a couple big hits when the potential for a sovereign debt crisis turned into a reality. In May last year the Euro plunged from 1.3300 to 1.1900 (1,400 pips) in a little over a month after it was learnt a rescue package of $144 billion to bail out Greece would be required. While it has since regained that loss in value and then some, when looking for a trading opportunity it is important we keep that event and its impact on the Euro in our memory bank. It is also events like this that leverage Merkel and Sarkozy’s largely uncompromising position at the EU Economic Council meeting when dealing with their fiscally irresponsible friends to the south. The European Stability Mechanism (ESM) while largely funded by Germany (contributing roughly 27%) looks to have stringent conditions embedded within it to begin the slow process of financially rehabilitating countries such as Portugal, which at the moment looks to be the EU member most in need of attention.
The Balance Sheet
In the liability category, it has been well documented that the high interest debt now working to be re-financed takes the cake. Rightfully given recent developments, this gets most of the public attention. If you look at the price action of the EUR/USD recently however, there has been an overall uptrend. On March 18 we witnessed the Euro pair break the significant 1.4000 level and then trade up as high as 1.4250 early in the same week as the March 24-25 EU meeting in Brussels. This disparity between debt concerns and recent Euro strength begs the question: Which elements within the Eurozone conglomerate economy are buoying the currency amid crisis discussions? In short, Germany and France (Europe’s two largest economies) are humming along like finely tuned engines. Inflation in the region is also ticking upwards. In Germany at the moment you get the impression that skilled workers are enjoying the luxury of choosing among multiple job offers. On the macroeconomic front, the capital flow outlook looks improved after ECB President Jean Claude Trichet’s recently reiterated hawkish comments on interest rates. Knowing full well this news would not be well received by bad debt countries, Trichet did not waver. This is the best reminder in recent memory of every central bank’s primary mandate: to control inflation. Stubbornly high inflation forced Trichet’s hand. Your opinion on whether an upcoming 25 basis point hike in April by the ECB (taking the target rate to 1.25%) will be enough to temper an inflation rate that is currently above acceptable levels will have a critical impact on any long term position you are considering taking in the EUR/USD.
Strength In Our Diversity
Often times when you read an annual report on a particular company or listen to a public address from their CEO you will hear this phrase. It means the synergies, ideas and opportunities that arise from a diverse workforce spanning different territories and focusing on various revenue streams makes the company an increasingly greater force over time. That diversity and flexibility also better prepares the company to absorb the occasional financial loss – expected or unexpected. Can the same be said for the Eurozone and its currency? When you see the somewhat inspiring action being taken here in March to help their “brothers by currency”, the logic seems to hold largely the same. While there will be some publicized drama regarding the concessions that will have to be made around the table at these meetings, each member country took a blow in one way or another from the required bailout of Greece and Ireland in 2010. Those wounds are still fresh and they will now go collectively to greater lengths to prevent a collapse or near collapse of one of its members in the future. And while the immediate measures are preventive in nature, they have a long-term growth vision behind it that cannot be lost. As you consider whether to become a “shareholder” in this currency by taking a long EUR/USD position, you have to view these meetings as a big positive. Unlike the political wrangling that too often occupies a weekend G-10 summit, there looks to be an accepted determination here to put policies in place that whether popular or unpopular in the short term, will almost assuredly provide more stability and predictability across the region. Significantly, this is the case when it comes to items such as loan terms and conditions, labour laws, welfare policy and any other areas where visible holes need to be filled. While there appeared to be some tension presenting itself during the March 11th weekend meetings and likely again when they meet at the end of the month, that shouldn’t be mistaken for lack of progress. Quite the opposite actually, and long term Euro bulls should be encouraged by these events.
Taking a Position
Once we have the full picture of the most critical factors affecting the value of the Euro relative to other currencies we’re approaching trade decision time. We’ve been highlighting EUR versus the USD here because this, hands down, is the most heavily traded currency pair in the market. In deciding whether to take a position, looking into the short history of the Euro would also appear to be a useful exercise. It is often forgotten that shortly after the Euro was first introduced in 1999, the IMF had to organize a joint intervention to prop up the currency as it plummeted fast and furiously after launch. At the time there were serious questions about the currency’s longevity. Since then the Euro’s time below parity against the USD (last seen in December 2002) is a distant memory. As the Euro now enters adolescence, there are certainly risks associated with being long the currency, namely no comprehensive solution resolution or a poor one at the conclusion of these debt-focused meetings. Remember that was the goal pinned up when this meeting schedule was first announced. While sounding lofty, EU leaders appear determined to not eat their words, least of all Merkel. At this moment, Euro bullishness should still be favoured despite the possible land mines that will have to be navigated between now and the end of April. For the Euro bull who has profited in recent weeks, but is concerned about the event risk the end of March and month of April poses, there is logic to sitting on the sidelines until a final resolution is released and consider resuming your long position. A break of 1.4200 again would present an attractive long entry point as a heavy number of stop orders on short positions should get tripped – accelerating the move upwards and setting sights on a target of 1.4500. With Libya tensions coming to a head after a UN sanction was approved supporting a limited form of military intervention, yet a dubious exit strategy, the coming days are certainly not light on event risk. For this reason, it is likely we will see the periodic flight to safety in the coming days, which encourages USD longs. Despite that, the Eurozone’s historic resiliency in troubled periods, the continued strong growth in its two largest economies, its upward outlook on interest rates, and a begrudging willingness to become a more financially responsible conglomerate points towards more gains for Euro longs heading toward the middle of the year.