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Euro to Surge

Friday May 25, 2012 16:31

The fortunes of Europe’s beleaguered euro currency have been heavily influencing US markets.  Today of course the great fear plaguing the euro is centered around Greece.  This profligate, unrepentant debtor nation seems hellbent on not honoring its commitments to the rest of Europe which could force its exit from the eurozone.  And though Greece’s economy is immaterial relative to greater Europe’s, traders are worried Greece forsaking the euro will trigger other troubled debtor countries to follow suit.

And if Greece proves the initial domino that ultimately leads to the eurozone fracturing, what is the fate of the euro itself?  This compelling line of reasoning has catapulted the short-euro trade to become the most-crowded macro bet on the planet.  There is a universal expectation the euro is doomed to spiral lower, with only the magnitude of losses in doubt.  This euro-to-zero sentiment is immensely popular.

But provocatively it is nothing new.  Since the euro was born in January 1999, every time it has been near lows similar euro-to-zero arguments were ubiquitous.  Yet the euro has still thrived, defying the naysayers every time.  In fact, between mid-2001 and mid-2008 the euro surged 90.5% higher in a mighty secular bull.  Even this week near new interim lows, the euro was still up 50.5% since its bull began!

The euro’s rise to prominence has been meteoric.  Today it is the world’s second-largest reserve currency and second-most-traded currency.  It now has more physical money in circulation than the US dollar!  It is used by 330m Europeans daily, and another 175m people use currencies pegged to it.  The euro continues to grow in acceptance and even preference by countries, central banks, and companies.

The euro is not going anywhere, the world needs a viable alternative to the US dollar.  This is especially true in light of the Federal Reserve’s relentless dollar inflation and Washington’s Greek-style rampant overspending.  Whether Greece stays in the euro or not is truly irrelevant.  Back in 2010 before its worst woes began, Greece only accounted for less than 1.9% of Europe’s GDP.  Today it is a rounding error!

This chart looks at the euro priced in US dollars over the past 4 years or so, since before late 2008’s stock panic.  The euro (blue) along with some key technicals are slaved to the right axis.  On the left in red is a construct I call the rEuro, or the euro divided by its own 200-day moving average.  Based on my Relativity trading model, it helps identify the euro’s tradable sentiment extremes of unsustainable greed and fear.

As this chart shows, a $1.26 euro is very interesting technically.  Ever since the stock panic, this has been the euro’s major long-term support zone.  Each time it plunged to $1.26, it soon rallied sharply in a major new upleg.  Whenever the euro approached today’s levels in recent years, traders got caught up in the downside momentum and expected this currency to spiral even lower.  That was the wrong bet to make.

Back in July 2008, the perennial euro-to-zero fears were a distant memory.  The euro was achieving all-time highs against the dollar, which itself was mired deep in a long secular bear.  But the euro’s revelry was interrupted by something amazing, a rare once-in-a-century stock panic erupted out of nowhere.  This terrifying event ignited the highest levels of fear we’ll see in our lifetimes, a literal fear superstorm.

Well unfortunately for the euro, it dominates the USDX at 58.6% of this index’s weight.  So with flight capital catapulting the dollar higher, the euro had to fall.  And it did, plummeting 22.0% in just 7 months from its July all-time high.  In October and November 2008, on the exact days the US stock markets hit panic lows (driving dollar buying), so did the euro.  Popular consensus argued it wouldn’t survive.

But the euro-to-zero crowd, as usual, overlooked a critical point.  The world needs a direct competitor to the US dollar, and for better or worse the euro is it.  Central banks need to diversify away from their heavy dollar holdings built up over decades.  Countries and companies that don’t like Washington’s disastrous mismanagement (rapid inflation, rampant overspending, zero yields) of its currency need an alternative.

So the wildly-oversold euro soon started surging again, right from $1.26ish levels where traders were wrongly hyper-bearish on it.  This fast euro recovery was mostly dollar-centric.  As the US stock markets stopped plummeting and bounced, flight capital hiding in the USDX quickly exited.  And the falling dollar quickly pushed the unloved euro higher.  The euro couldn’t stay near its major support for long.

This second $1.26 approach in March 2009 just as the US stock markets bottomed is very illustrative for today.  Even though the euro’s initial attempt to launch a new upleg just after the stock panic failed, its strong support held and formed a double bottom.  So just because the euro has approached this major support line twice so far in 2012 certainly doesn’t mean a major euro upleg isn’t imminent again.

The euro would ultimately surge 21.4% higher in 12.2 months in 2009’s major upleg, ridiculing the euro-to-zero naysayers whose ideas were so popular during the stock panic.  But by then the euro was overbought, it was trading above 1.08x its 200dma.  As the light-red rEuro line in this chart shows, once the euro rallies fast enough and far enough to hit this metric a correction is due to rebalance sentiment.

I wrote an essay on this in late-May 2010 called Euro Panic Buying Op.  The day it was published the euro was under $1.26, and the euro-to-zero crowd dominated discourse.  There were widespread predictions the euro would fall to parity soon ($1.00), far lower than it was trading. 

But the few other contrarians and I were right, the euro would rocket 24.5% higher over the next 10.9 months in a massive upleg just as predicted. 

After that massive upleg born out of extreme fear and despair much like today’s, the euro eventually grew overbought again in spring 2011.  Greed was excessive, sucking in everyone interested in buying anytime soon.  This left only sellers so the euro started correcting again.  And just like in its 2010 correction, once again Greece fears flared to help accelerate this latest correction’s decline late last year.

latest round of Greece fears drove the euro near $1.26 support in mid-January, and again this week after the Greek government that agreed to the terms of the second bailout lost this month’s elections.  So traders are once again terrified by little, immaterial, perpetually-broken Greece.  What if it leaves the eurozone to fire up its dusty drachma printing presses again?  How can the euro weather such a crisis?

So the same old euro-to-zero arguments that have come out of the woodwork at every major euro low since its 1999 introduction have reared up again today. 
But once again I’m taking the contrarian side on this one.  When everyone thinks a price that has already suffered a long decline is heading lower indefinitely, they are almost always wrong.  The euro is nearing oversold levels and fear is out of control.  Euro shorts are everywhere, hedge funds are heavily short this currency just like they wrongly were in spring 2010.  And euro bulls are scarce, seemingly extinct.

So the oversold euro is due to surge, probably to enter a major new upleg.  And the last two major uplegs after extreme euro fear near its $1.26 major-support line have averaged 23.0% gains over 11.6 months each.  A similar upleg today would carry the beleaguered euro up to $1.55 by next spring, which is not far from its all-time highs.  This would certainly send the euro-to-zero crowd scurrying into hiding again.

Ever since the stock panic, there has been a strong negative correlation between the US dollar and US stock markets.  So whenever traders see the dollar rally, they tend to sell stocks while futures traders definitely dump commodities.  The recent sharp May plunge in both the US stock markets and commodities prices is the direct result of the fast-rallying USDX.  And that was driven by the Greece-induced euro plunge!

So when the euro reverses out of today’s extreme lows and starts surging higher, the US dollar is going to get hit hard.  All the selling pressure on stocks and commodities will evaporate immediately.  And all the capital hiding out in the dollar will start flowing back into these oversold arenas.  So euro strength will effectively spark major rallies in stocks and commodities, starting to rebalance May’s rotten sentiment.

And when both stock markets and commodities recover, the biggest beneficiaries will be the hyper-oversold commodities stocks.  The carnage in this sector has been unbelievable lately, with many commodities stocks nearing panic levels even though the prices of the commodities they produce and their profits are far higher today.  The imminent surge in the oversold euro should quickly reverse this.

The bottom line is the euro is due to surge.  Greece’s long-known dysfunctionality has driven the euro to major multi-year support again.  But these levels have held strong even through and since 2008’s stock panic, the greatest fear event of our lifetimes.  Whenever the euro falls this low, it is oversold and fear is excessive.  Like anything else suffering such extremes, a sharp rally soon erupts to rebalance sentiment.

So the smart bet to make today is the contrary one, fighting the euro-to-zero groupthink and being long this battered currency.  Sooner or later some catalyst is going to drive some euro strength, which should ignite a monster short-covering rally to kick off the euro’s next upleg.  The best part is this will hammer the overbought dollar, paving the way for capital to return to oversold stock markets and commodities.

Adam Hamilton, CPA
May 25, 2012

Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Metals Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in precious metal products, commodities, securities or other financial instruments. Kitco Metals Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.

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