The Euro Mess is the Dollar's Gain

It was just four days ago when the world celebrated the European rescue. Now that has all changed. Carl initially pointed out that the European bond market was not happy with the bailout, and now everyone has joined the party. Not only are 10-year Italian bond yields surging to a worrisome 6.25%, but the Euro is selling off heavily and European financial stocks are well below pre-bailout levels. This is all possible due to Greek Prime Minister George Papandreou. He has called a referendum on the new EU aid deal, which could backfire if his coalition loses the vote.

Due to the increasingly hilarious (in an uncomfortable sort of way) situation in Europe, our Rising Dollar position has rebounded very nicely. The chart below shows the Dollar Index. We were very excited in September when the price level broke above the green line, but became nervous when the green line broke in October. However, after an amazing 4% rally, the index is now once again trading above the green line, the 50 Day Moving Average and the 200 Day Moving Average. We're glad to have our safe-haven hedge in a Rising Dollar Fund.

The European News: A Game-Changer or Bull Trap?

In the after hours yesterday, news leaked out about an apparent impasse between the banks and European leaders, and markets seemed poised to sell off again on another European snafu. By 9pm details emerged that a deal had been cut with the banks regarding haircuts on Greek bonds, and the mood in Asian markets quickly turned around. By the time I woke this morning, a plan had been hatched in Europe that put the markets into celebration mode. Risk assets love the fact that a tangible plan has finally emerged, and today markets are partying like it’s 1999.

Some of the key parts of the plan are:

• Private investors have agreed to realize 50% haircuts on Greek Bonds.
• Banks are required to recapitalize using a 9% threshold of the highest quality capital.
• EFSF will provide bond insurance for some amount of bonds from Euro issuers, and could potentially lever the EFSF to just over 1.4 trillion USD.
• Greece will get slightly more bailout money than what was agreed upon in July.
• The ECB will keep buying Sovereign Bonds as needed.

As always, the devil is in the details, and looking under the hood there are already some relevant questions being asked about the plan. For instance, why is the International Swaps and Derivatives Association (ISDA) not going to consider the 50% haircut a credit event on Credit Default Swaps (CDS) insuring Greek bonds? If ISDA refuses to recognize this effective default, will there be unintended consequences coming from holders of defunct insurance that take a loss with no insurance? If banks are forced to raise capital, will they do so by curtailing loans which could spill into the European economy? For that matter, is the 9% capital a sufficient amount in an economy that appears to be decelerating rapidly? Etc., etc.

We will spend the next few days parsing the language of the plan, monitoring credit market relationships for signs of divergences or confirmation, reviewing key technical measures, and assessing a variety of respected analyst opinions. Now that that European news has finally hit, it is time for Pinnacle to assess whether this plan is a game-changing event or a bull trap for investors who are late to the party.

Coordinated Policy Action

Today brought news that five central banks – the Federal Reserve, European Central Bank, Bank of England, Bank of Japan, and Swiss National Bank – have teamed up to provide unlimited short-term U.S. dollar funding to troubled European banks. It was a coordinated policy response designed to calm increasing market concerns about another credit freeze, this time centered in the European banking system. The market reacted positively to the news, with stocks sharply higher globally, the euro rallied, and bonds were down.

While it remains to be seen how much of an impact this program will ultimately have, a strong, globally coordinated policy response is high on the list of “risks” to our current defensive investment stance.  For the past year, instead of global coordination, we’ve mostly seen ad hoc, unilateral attempts to combat structural economic problems from various countries and central banks. There has been little in the way of coordination, and somewhat predictably, most of the programs have enjoyed at best only fleeting success.

Today’s policy action is notable for its coordination, but seems designed mostly to address the growing liquidity crisis among European banks. It does nothing about solvency, which is the crux of the problem over there. However, if political leaders in Europe are ever able to put together something meaningful to tackle the solvency issue, while at the same time offering a globally coordinated monetary response, that could be a force powerful enough to spark another big rally in asset prices, and would likely cause us to abandon our current defensive positioning in order to participate. This particular program, while well received today, doesn't seem to be enough to do that on its own.

Dollar Starting to Pay Off

For months we have been wondering when the dollar will finally start to move higher versus the euro. The problems in Europe are massive and they will not go away. And yet the Euro seemed to be hanging around -- the damn thing has alligator blood. Well, the dollar is finally having its day. The market is pricing in a 95% chance of default on Greek debt, and Germany is prepared to shore up German banks in case of default. Euribor is spiking once again and the global system is experiencing tremendous amounts of stress. This feels eerily similar to 2008, only the epicenter is in Europe.

After a four month consolidation at levels close to the all-time-low in the dollar, the greenback has risen above the 76 range resistance and is trading above the 200 Day Moving Average (yellow line) for the first time since September 2010. Momentum is making a new high and the move is pushing the dollar above its one standard deviation trend as measured by the Bollinger Band. These are all great technical developments for our currency, but they are not great developments for the ‘risk assets,’ including stocks. Since 2008 the dollar has a 55% negative correlation to the stock market. That means when the dollar is up there is a very good chance that the stock market is down. Today, the S&P 500 is falling 2.5%.

For a brief moment there, I was in a good mood.

Portugal Government Collapses and the Euro… Goes Up

Overnight, the Portuguese government collapsed following a vote in parliament against a new austerity package aiming to reduce the country’s deficit. Prime Minister Jose Socrates resigned after the vote, as he vowed he would do if this deficit reduction was not approved. He claimed that raising taxes and implementing severe cuts in spending would lead to substantial debt reduction and allow the country to avoid a European bailout. So in essence, the “no” vote has now guaranteed a bailout will come from the European Union summit taking place today and tomorrow at which leaders are discussing the euro-zone debt crisis. The market has a lot of faith in those leaders to quell debt fears as the Euro, currently trading at $1.42, gained against the dollar today.

Traders were quoted as saying the Portugal bailout had been priced into the market already, and all the selling necessary has occurred. Looking at the chart below there doesn’t seem to be much selling in the last few months as the Euro is flirting with 12 month highs. I will be interested in watching this level to see if the Euro breaks to new highs or finds resistance here.

If you ask me, this seems to be more of a statement regarding the dollar than the Euro. The European Central Bank has expressed interest in raising interest rates to counter inflation problems which supports the Euro, and the Federal Reserve is certainly not at that point. If Bernanke’s ultimate goal is to debase the currency then I certainly think he is winning this race. And you know we will continue to hold gold to hedge currency debasement until he releases the throttle.

Chart: Rydex Euro ETF (FXE)

Follow the Euro

The Euro and S&P 500 don’t have a very high correlation over a long period of time. In non-geek speak, that simply means that the movement in one does not translate to a movement in the same direction of the other all that often. For a quick lesson in correlation, statistically, a correlation of 1 between two variables is considered to be “perfect” correlation, meaning that the two move in tandem, all the time. -1 indicates an inverse correlation, meaning that two variables move in totally opposite directions all the time. A correlation of 0 simply means there is no correlation; the change in one security means very little to the change in the other. When I computed the historical correlation between the Euro and S&P 500 on Bloomberg, it is as low as 0.035, meaning there is very little long term correlation (it’s close to 0).

Lately, much market myopia has been on the evolving crises in the Euro-zone, and the correlation between the two has been increasing. Bloomberg indicates a correlation of 0.5 now, but anyone that’s been watching tick-by-tick trades knows that moves in the Euro often appear to lead the equity markets these days. If you don’t believe me, then I suggest that you start watching the daily charts of the Euro exchange traded fund (FXE) vs. the S&P 500 (SPY). Why does this seem to be the case? Well, I suppose we could blame it on hedge funds, computer linked trading devices, or the fashionable scapegoat du jour, which happens to be BP. Whatever the real reason is for the increase in correlation, we may never fully know. However, if you want a clue as to which way equity markets may be headed, just follow the Euro.

Another Misguided Ban

You might recall during the height of fear in September 2008, the Securities Exchange Commission halted short selling of financial stocks in an attempt to protect investors and markets. They felt that the integrity of the markets was being questioned and this move would restore equilibrium to markets. You might also recall that financial stocks (as measured by the XLF – financial sector ETF) fell from $18.50 to $6 per share (a 67% decline) from September 2008 to March 2009. It is certainly evident in hindsight that excessive shorting was not the enemy of financial positions. But it’s nice to place blame elsewhere!

Now, it seems that Europe may be heading down the same path. Today, Germany’s financial markets regulator announced that it would ban naked short selling and naked credit default swaps on euro-zone debt, and ban short selling in 10 financial/insurance stocks through March 31, 2011. The reason given for the new rules, as you may have guessed, is that massive short selling has led to excessive price movements which could crash the entire financial system. And apparently they fear that crash could occur in one night, since the ban goes into effect at midnight local time.

It has been pointed out that this is merely a symbolic move by the German regulator because most naked short selling occurs in London which is outside their jurisdiction. However, it highlights the inability of European nations to face the real problem. In 2008 financial stocks were sold due to toxic assets littering their balance sheets, and now Euro bonds are being sold due to fiscal problems and excessive debt loads. And just as the financial stocks in the U.S. continued to fall after the short selling ban in 2008, the market will probably find a way to tell the European leaders that this type of action does not correct the underlying problem of fiscal mismanagement. The euro was down over 1.5% today so I think that message is already coming through.

Euro At A Critical Spot

In the wake of the massive, $1 trillion bailout package concocted by the European Union, IMF, and European Central Bank last weekend, conventional wisdom was that the euro would get a big boost. After all, it had fallen by more than 16% percent since the news of Greece’s budget problems first surfaced late last year. However, after a brief reprieve during the trading day on Monday, the euro has rolled over and fallen back down near the lows from last Thursday (currently trading at $1.26 - see chart below).

The lows around $1.23 - $1.25 from late 2008 and early 2009 are critically important. If the euro breaks lower than that, bearish investors may pile in more than they already have, driving the currency even lower, perhaps back towards parity with the U.S. dollar. That would be a crushing defeat for European leaders, since the recent bailout package was designed as a “shock & awe” attempt to save the currency and remove growing doubts about the ultimate survival of the European Monetary Union. A fresh drop in the currency would reignite fears of contagion and de-stabilization, likely leading to another bout of volatility in the financial markets.

Euro Breakdown

We’ve been watching with great interest, as have a lot of other investors and observers, the behavior of the euro over the past several weeks. It’s fallen rather quickly from $1.51 to $1.41 in that time. Today, it fell decisively through its 200-day moving average, which is widely watched as a longer-term trend indicator. The drop has largely been blamed on growing economic problems in that region, particularly in Greece, which is scrambling to try and repair its tattered public finances. The potential ramifications for the other eurozone countries, depending on how the Greece situation is ultimately resolved, has reached the point that many are starting to question the longer-term viability of that monetary union, and the euro as a common currency.

Why is this important to us? Well, the direction of the U.S. dollar is near the top of our list of things to watch in 2010. One of the key questions is whether it made an important bottom in 2008, when it rallied during the flight to safety caused by the financial crisis. Although it sold off again in 2009, it held above the 2008 lows, and has recently been rallying. We’ve been of the opinion that the structural headwinds facing the U.S. economy – bloated debt levels, large budget deficits, and high unemployment – would cause the dollar to resume its decline and eventually make new lows. But currencies are largely a relative game, and the severity of the problems faced by the other major industrialized economies (i.e., Europe and Japan) is causing us to reassess our view, and wonder if the greenback might continue to benefit from simply being the lesser evil.

Euro with 200-day moving average (blue line)