Testing the Euro

It may be time for a little summary of how I see the fundamentals situation right now.

This past week has been a rich one in event on the EUR/USD front, we first saw the EUR rebounding from 1.385 to over 1.403, then back down to 1.365, all these moves being fed by news from the ECB supporting Greece, and worrying about Portugal, Italy and Spain.
The rebound has been discounted as a speculative action to the news of the ECB support to Greece, and the bubble has deflated as fast as it did inflate.
There was no real surprise in that, but the drop signals something bigger at play. This is the first big test ever for the Euro, and the fundamental question is: Will the ECB be able to impose a strict budget and economic policy to its member nations?

The way this question is answered will be important in the sense of establishing the status of the EUR as a serious reserve currency. As of now, this status is far from obtained yet, indeed, why didn't the EUR replace the USD as a safe haven currency?
Clearly, the social and political situation of Europe is relatively stable, the EUR currency is supported by the largest economy in the world, but the basic problem of the EUR is about sovereignty, political authority. If a single country had gathered the objective parameters that are behind the EUR, its currency would be the safe haven currency of the world. However, in the EU, there is not one single political voice, there is actually no clear warranty that all member countries will maintain their participation to the European framework if things turn bad. This ambiguity about the EUR is what, in my view, explains that it is, so far, not even considered as a potential reserve currency.
If something goes wrong with the USD, the US government is able to act upon it in a sovereign way, it can raise taxes or lower them as it deems fit. Nothing, within USA will oppose these decisions if they are clearly motivated by the defense of national interest, and the USD is doubtlessly considered as such.

The current crisis, in Greece, Portugal, Italy and especially Spain, will be the test for that. If it fails, if one of these countries strays away from abiding by the ECB recommendations, and somehow displays a lack of responsibility towards the other EU members, the EUR may not survive in its current form. On the other hand, if it succeeds, the EUR will have made a great leap towards being considered a reserve currency.

Meanwhile and according to the news about the troubled european countries and their interpretation, the EUR/USD pair should display high volatility with a medium-term down-trend, where I see the EUR retesting the low 20s.

EUR/USD outlook

Technically, the EUR/USD may have reached its top as the 61.8% fibonacci retracement of the range 1.6040/1.2329 at 1.4842 (even though the key resistance is 1.4867) and could now go for a dip back into the 1.2s (albeit some resistance on the way).

On the fundamental side, the EUR is again now over-valued. Besides, in a recent report, the OECD wrote:

"The reform of global exchange rate regimes and the dollar reserve currency problem is extremely important, but is also unlikely to be achieved any time soon." From The Financial Crisis and the Requirements of Reform - Adrian Blundell-Wignall

The USD is therefore strengthened in its position as a reserve currency in the medium term.
In terms of financial regulations, the G20 has clearly achieved nothing but a bunch of populistic tricks that will have no consequence whatsoever, and as explained in the OECD report, this should lead to a sluggish recovery, especially in Europe and USA.
In this context, the recent rise of the EUR, upshot of an early enthusiasm, should be short-lived, as the reality of national deficits, progressing unemployment, limited credit and falling consumption will set in.

Who is selling the EUR?

Today saw some remarkable activity in the EUR rates.
This morning at about 10:15(CT), there was a sudden drop of about 50PIPS on the EUR/USD, then at 13:18, -30PIPS in less than a minute, and at 16:12, more than a 100PIPs drop in less than 5 minutes, clearly some big accounts are liquidating their EUR reserves.
All this may find an explanation in the remarks from Juncker about the EUR still being over-valued.

During the same time, the DJ dropped by 344 points, so the US stock market does not seem relevant with regards to the current movements of the USD, stronger forces seem to be at play here.

This certainly invalidates my earlier analysis that linked the future of the USD to the US economy, and especially to the unfolding of the current crisis. At least for now, the market appears to follow the consensus of the central banks in working towards a strengthening of the USD against the EUR, or rather towards the general weakening of the EUR.
As for today at about 5PM CT, the EUR has lost about 300 PIPs against the USD, and about 600 PIPS against the JPY. Interestingly the USD also dropped by about 250PIPs against the JPY. Japan seems to be at the heart of the matter in these movements.

The big question is up to which level this weakening will continue ? I, for now, expect to see it going towards the 1.3, or even 1.2 USD mark, if the current logic is respected. At this level, we shall see what the EU deciders say about the overvaluation of the EUR.

EUR/USD medium term outlook

These last few weeks, I have been holding the belief that, for the next year or so, the EUR/USD will have a high volatility between 1.4 and 1.6.
This week, it dropped from 1.55+ to 1.5, that's an impressive drop, and we start hearing from a possible big trend reversal, possibly the outset of an upward trend for the USD, the materialization of the strong USD policy promised by Paulson and Bernanke beyond the customary rhetorical value such chantings have.

As of now, I have been considering the risk of being wrong on the upside higher than the one of being wrong on the downside. Should I then reconsider my approach ?
Anyway, here is the details of my thought so far, up for comment:

My first assumption is that EU economy is still overall structurally healthier than its US counterpart, even though some banks have suffered from the credit mess, the level of the write-downs (and the depth of their consequence in the overall economy)is still very far from what we saw in US.

Secondly, I assume that there is a general psychological bias for the USD, whereby the investors actions (in EUR/USD particularly) over-react to bad EU news, and under-react to bad US news. This bias is actually justified in view of the market dynamics, where the european markets mostly mimic the US market. What I mean by bias, is that it does not reflect pure fundamentals, but is mostly a psychological attitude in the mind of investors that have spent most of their lives with considering the USD as the reference currency, the safe haven away from the world uncertainty. This bias however is really challenged by the current crisis, and it tends to fade a bit, and may well vanish totally, which is why, until now, I considered my risk of being wrong on the upside higher.

Now, considering that Paulson and Bernanke really mean to walk the talk, can they really do it? Clearly, the Fed may be able to do a few things, especially with the support of the ECB and the BOJ, both having a strong interest in a strong USD to ease the pressure on their respective economy. We can then reasonably expect a collaboration between the three largest players on this market to push for a strong USD. But is it enough?

US economy is expected to deteriorate further. According to Krugman, some bad loans are going to mature up to 2011, real estate is expected to continue its drop, being only half-way through according to some estimations.
In addition, USA is going to have a new government in less than 6 months, one who will inherit some serious liabilities from the current one. A new government, elected on the current buzzword of "change", can hardly be expected to have a tight budgetting poliy in his first year, especially in view of a reform of healthcare, of necessary expenses on infrastructure, on energy policy,...etc.
Such a policy may seriously strain at a strong USD policy, which I rather see as incompatible with running an ever-increasing deficit (something about which the investors should see the EU, despite some very bad members, relatively immune from, given the conditions of the Growth and Stability Pact).

So, will the USD pull it off, and are we really seeing the first signs of a complete reversal, or is it just the last song of the swan before its slide into the 1.8 or so, just awaiting the next big write-down ?

JP