RealMoney Silver - The End of the Euro Rally

The End of the Euro Rally
By Marc Chandler
RealMoney.com Contributor
4/18/2008 11:18 AM EDT

Like an errant child defying his parents before quickly capitulating, the euro is ending the week on a soft note after reaching record highs against both the U.S. dollar and the British pound.

Downside corrections in the euro this year have been brief (four to six days) but sharp (5 to 6 cents). If this pattern, which of course really reflects the behavior of market participants, is to be repeated, the euro is likely to fall back toward $1.53-$1.54 by late next week.

Also in this vein, we note that the euro has not closed below its 20-day moving average since Feb. 18. That average comes in near $1.5753 as the week draws to a close.

To be sure, such short-term patterns are not the kind of thing one wants to bet the proverbial farm on, but it is a ballpark guess of what to expect in the near term. More than that, it provides a bit of a metric to evaluate the pullback in the euro. At the same time, a euro pullback of the magnitude and duration noted above would likely be regarded as "normal" by the euro bulls and momentum traders.

Momentum vs. Value

Momentum traders have had the whip hand this year. The rise in risk aversity undercut carry strategies, which had been the go-to play in the currency markets for so long, and the yen and Swiss franc outperformed during the credit crisis. The end of the carry game surrendered much of the foreign exchange terrain to the momentum traders.

Value investors, who expect their investment to return its underlying worth, essentially employ mean-reverting strategies, with the mean here being value. They want to buy low and sell high.

Momentum traders are a different kettle of fish. They buy high, not wanting to pick a bottom -- that is for value investors -- and expect to sell even higher. Momentum traders are trend followers, buying when it is going up and selling when it is going down.

Those momentum traders have been whipsawed badly in recent days. The knee-jerk reaction to the G-7 statement was to sell the euro, but in less than 24 hours it had recouped the initial sharp loss. As momentum traders scrambled to re-establish their long euro positions, they lifted the single currency to record highs against the dollar and sterling. Then at week's end, the euro sold off hard again. Momentum traders appeared to throw in the towel after the higher-than-expected eurozone March CPI (3.6% year over year) failed to push the euro through the psychologically important $1.60 threshold.

It stands to reason that how market participants interpret the news stream affects prices, but the opposite is also sometimes true. Sometimes the news stream is interpreted through the lens of the price action.

This is to say that the psychological significance of the rejection of the $1.60 level and the subsequent reversal of the euro's fortunes will likely encourage market participants to see the news stream as euro-negative.

Fundamentalists' Lament

While many market fundamentalists are disturbed by the aggressiveness of U.S. officials to avoid what they perceive to be a cleansing deflation of debt, many investors are concluding that it doesn't pay to take on city hall. U.S. officials are determined, and the instruments at their disposal still seem adequate, so it seems the fundamentalists will not win this battle. The fundamentalists will continue to warn that without the baptismal waters of a full-blown financial crisis -- until many more debtors and creditors are punished for their greed -- the next crisis will be all the worse. Paying the piper can be delayed, but it will still be a witch.

To be sure, the S&P Case-Shiller index shows no letup in the pace of declines in U.S. house prices, which in some ways is at the vortex of the financial crisis. They have fallen every month by more than the previous month for nine consecutive months. The U.S. economy is still stagnant and possibly even contracting slightly here in the first half of 2008, but the market is being forced to give the Federal Reserve the benefit of the doubt in its forecasts for a better second half.

In contrast, the ECB seems rigid and all too willing to risk a sharper downturn in the economy in an attempt to demonstrate its anti-inflation credibility. The IMF has sharply cut its GDP forecast for the eurozone this year to 1.4% this year and 1.2% next year. It claims the ECB has room to cut interest rates. The ECB obviously disagrees. Although there was some strong rhetoric after the March CPI report, it is difficult to take seriously any implied threat to raise interest rates.

Europe still typically relies on exports to service foreign markets, while the U.S. services foreign markets more by building and selling locally (U.S. sales by majority owned affiliates will sell something on the magnitude of 4 times goods that the U.S. will export this year). There may be much talk about how a strong euro is a sign of the correctness of official policies, but the truth of the matter is that many in Europe prefer a stronger dollar in general, not just now.

Strains within Europe appear most acute when the U.S. dollar is weak. Such strains are evident now. The premium that Europe -- both within the eurozone and without -- has to pay above Germany has widened markedly. Countries on the periphery -- like Portugal, Spain, Greece and Italy in the past -- would attempt to regain competitiveness lost by devaluing. France, if the pressure became unbearable, might seek a revaluation of the German mark (rather than a devaluation of its franc). This path has been cut off.

I believe that the U.S. will be looking better six months from now, and the eurozone could be looking worse. This is a market for value investors, which in the currency markets means the dollar. According to various models of valuation, the dollar has rarely if ever been cheaper, nor Europe dearer.