Can the Euro Go to $1.10?

January 10th, 2012
in contributors

by Michael Sankowski, Traders Crucible and Trend Following 101

Quick – what’s been the most persistent idea in Currencies over the last 2 years?

euro-bills-cutIt’s the link between the level of the EURUSD and the odds of a European catastrophe of some sort.

The level of the EURUSD currency pair has been viewed as something like the odds of a euro breakup or banking blowup ever since Greece first started making front page news in October of 2009.

Since then you the EURUSD has been a sentiment gauge – when it’s over 1.4000, all was fine. Between 1.3000 and 1.4000, well there might be problems. Below 1.3000 you got absolute panic.

But in the last few weeks, this link has been severed almost entirely. The level of the EURUSD no longer indicates the level of danger for the euro.  And I think this gives the EURUSD the opportunity to move significantly lower over the next several months.

Follow up:

The old conventional wisdom was uncertain about the ultimate willingness of the ECB to purchase this debt. There seemed to be a limit to how much QE might be done – and the risk of someone leaving the euro.

Therefore, any declines the EURUSD were a cause for panic – because it was viewed as information somebody was getting closer to leaving the euro, or that some bank was going to explode.

But this increased panic forced the euro countries to act. As the panic increased, the odds of some new program being announced became greater – which puts something like a floor on the EURUSD.

The new conventional wisdom in Europe is pretty simple. The new European Central Bank president is “closer to Bernanke than to Trichet”. This means the ECB will purchase just enough sovereign debt to keep the crisis from exploding. These purchases help to save the euro, but are viewed as very inflationary.

These purchases of debt are Quantitative easing by another name. QE is viewed as inflationary by most observers. The backstop of the ECB purchasing debt becomes a reason to think the euro will go lower.
But a lower EURUSD is not a reason to panic and pray for some sort of bailout or new program. It’s just a rational response to QE from the ECB.

I don’t think QE causes much or even any inflation, but I’m just one guy. Look at Japan’s repeated and gigantic QE over the last 20 years – and how much inflation does Japan see? And the U.S. has done about $3t total of QE, and yet inflation is around 2%. QE doesn’t cause inflation.

Still, my opinion on this doesn’t matter. What matters is most people strongly believe QE does cause inflation. Fighting the crowd on this one would be very dumb.

And with the ECB engaging in what might end up as unlimited QE to keep the euro together, the conventional wisdom has changed. The new conventional wisdom isn’t entirely accepted yet, but it will be.

I think at this point, it’s good to point out Germany is very happy with a weaker EURUSD. I’ve suspected they’ve been stringing out the crisis as long as possible to keep a lid on the EURUSD.

Germany has a very large export sector, and a weaker EURUSD helps the German economy tremendously. In fact, it’s hard for me to see comments from German finance ministers as anything but attempts to talk the euro lower by threatening a crisis they know they can prevent at any time.

In other words, Germany won’t complain about a weaker euro, only about the QE causing the weaker euro.  Severing the link between the EURUSD level and catrosophe allows the EURUSD to move lower on concerns about QE without the threat of an overnight rescue deal.

So I look for a weaker euro over the next several months as the new conventional wisdom takes hold.  Now the final level of the EURUSD isn’t clear. However, we do have some indications on how low it could go.

Remember, much of the reason the euro stopped in the 1.1800 level was on rumors of a deal to stop the panic in the eurozone.

Now, instead of a deal to stop the crisis, the near term solution for the crisis is to perform more quantitive easing. Since this is viewed as very bearish for the EURUSD, we now have a situation where the lower the euro goes, the more likely the ECB is to do something that should push the EURUSD even lower.

I think this puts the old lows of 1.1876 in play and more. If we simply extend the channel formed by the movement of the EURUSD over the last few years, it implies a low in the 1.1100 – 1.1200 level. Here’s a chart.

Still this isn’t all. I make the case the EURUSD formed a massive head and shoulders over the last year – and just broke the neckline.

When I take into account the technicals facing the euro, along with the new conventional wisdom, I see a potential for a much lower EURUSD.

Please note this isn’t pure trendfollowing in this analysis. However, I’ve found it very helpful to be aware of whats really happening in the markets over the years – plus I am a total market geek!

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About the Author

Mike Sankowski, is a financial writer and trader. His 20 year financial background spans working for hedge funds, trading at the CME, and designing trading and clearinghouse products. His website is where he comments on monetary theory, economics and trading.  He has also started a new blog,  Trend Following 101. He is the creator of the TC rule for fiscal policy. He is a CFA and CAIA Charterholder. He spends his free time with his family driving the kids to hockey, and is part of the Box Set Authentic musical collective.

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  1. Forex Trader Email says :

    Nice post. During your trading, what’s your best trading strategy you trade with. Personally to implement a momentum strategy where I look forex instruments that are trading out of a trading range. Any opinions on that method.
    Thanks in advance

  2. I use trend following all the time and have a trend following program.

    Momentum trading in FX can be tough. In the last few years, it's worked well in AUDUSD, EURUSD, USDCHF, and to a lesser extent in GBPUSD.

    The USDCAD and USDJPY has not been favorable to momentum style trades.

    I'd use traditional trend trading techniques on this, where stops are based on volatility of the market.

    I think the next 6 months will be very good for momentum trading in the currencies.

    The new consensus in the euro combined with the new Japan inflation target should push these two currencies in one direction.

    The CAD and Crude oil are highly linked below $90/barrel. Above $90, the relationship becomes more difficult to parse. However, I do think there is a huge chance of a massive down draft in crude oil.

    Steve's article is excellent on how higher energy costs cause recessions. If we get a recession, we have the situation for a huge blow out in crude prices - high supply and low demand plus a recession. This would be cause the CAD to tumble.

    So in those three currencies, I see a potential for nice momentum style trades.

    When using momentum trades, I'd also look at carry trade interest rates.

    Also, I just read John Harvey's book on Currencies, called Currencies, Capital, and Crisis. It's excellent and provides a great fundamental model of how to think about capital flows impacting the prices of currencies.

    With a momentum trade, you can overlay the fundamental analysis of the capital flows - which with China in the game have tended to be more persistent than in the past.



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