Analysts Consider Fate of Euro

Where once it believed the euro was fated to an untimely demise due to a global financial meltdown followed by a regional debt crisis, it now appears the …

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Where once it believed the euro was fated to an untimely demise due to a global financial meltdown followed by a regional debt crisis, it now appears the currency may struggle out of the mire to live another day thanks to large liquidity injections and a halting but noticeable U.S. economic recovery. The euro actually rose in the first quarter despite continued unease about the state of Greece and the potential problems still lurking in Ireland, Italy and Spain. Experts expect elections in Greece and France may cause further currency instability, but look to interest rate differentials between the U.S. and Germany and the correlation between the euro and the S&P 500 for signs of what the beleaguered currency may do next. For more on this continue reading the following article from TheStreet.

1. As the world took a step away from the proverbial abyss with the firming of the U.S. economy and the European Central Bank’s massive liquidity injections in the first quarter, the dollar suffered.

The re-establishment of positions that were liquidated in the fourth quarter and the unwinding of part of the large long dollar positions amassed were key drivers.

Those moves appear to have run their course. The dollar will likely trade better in the second quarter than in the first.

The main exception is the dollar-yen, where the yen is likely to recoup some of its outsized losses from the first quarter.

2. As the euro rose in the first quarter, implied volatility collapsed, falling to its lowest levels since Lehman Brothers’ demise.

Even if one does not trade options or follow them closely, it is important to appreciate that the compression of volatility is often like a coiled spring, and tends to precede large spot moves.

With volatility falling as the euro rose, it’s likely to increase as the euro falls, and this is what has begun happening over the past couple of sessions.

Also judging from the pricing of puts and calls (as in the three-month risk-reversal), the discount for euro calls in late March fell to its lowest level since the first quarter of 2011.

However, this is reversing as participants buy puts (volatility is rising, so premium is being paid), and this also reflects the ascendancy of euro bears.

3. It is not just the case of the shift in views about the prospects for QE3. We have argued the economic conditions in Europe have deteriorated. We are concerned that there is still no closure in Greece despite the PSI. Italian and Spanish bond yields are rising, not falling, as are credit default swap prices.

4. In addition, there are a number of political events that pose risks to the euro over the next several weeks.

Greece and France hold national elections. In Greece, it is not clear that the current coalition of the Panhellenic Socialist Movement and New Democracy is going to secure a majority, warning of possible concessions to less pro-European smaller parties.

In France, although the first round appears to have tightened, Francois Hollande still enjoys a large lead in the all-important second round.

Italy will hold municipal elections next month, and they will be seen as a referendum on technocrat Prime Minister Mario Monti, whose public support has waned since his push to weaken the infamous Article 18, which ossified the Italian labor market.

Germany holds two state elections, which should not be much of a market factor. Further erosion of support for the Free Democratic Party increases the likelihood that next year’s national contest produces another Grand Coalition between the Christian Democratic Union/Christian Social Union and the Social Democratic Party.

Although Irish referendums have had market impact, this time that is likely to be different. The polls show that a comfortable majority favors approving the fiscal compact.

In addition, unlike other referendums, the fiscal compact is to be decided by a qualified majority, which means the unlikely veto would not derail the compact but simply cut Ireland off from further aid, should it be necessary.

Lastly, we note that the Dutch government nearly collapsed last week, and while it survived, it has yet to resolve the underlying budget problem.

5. The technical support for the euro has weakened considerably. The breakdown has followed the repeatedly unsuccessful attempts to push through $1.34.

The measuring objective of what may be a double top is near $1.3100, but the bottom end of the euro’s trading range is closer to $1.2975-$1.3000.

The five-day moving average is poised to fall below the 20-day moving average, indicating that short-term trend followers and momentum players are likely to be more inclined to sell rather than buy the euro.

Although this signal has whipsawed participants in recent weeks, it does have a good record of catching big moves.

The lower end of the euro’s trading range is also seen by some technicians as the neckline of a larger head-and-shoulder’s topping pattern, which if broken projects toward $1.25.

Based on current spot and volatility levels, indicative pricing suggests almost a 50% chance of testing the mid-January low near $1.26 here in the second quarter.

6. We have often found that the euro is sensitive to changes in the interest rate differential between the U.S. and Germany.

In the past, a flare up in the European debt crisis has led to safe-haven flows into Germany, pushing down its interest rates and widening the differential in the U.S.’s favor.

Although we have highlighted the risk of the re-emergence of eurozone tensions, growth differentials also seem to be fueling a widening of the interest rate spreads. The 10-year spread is at its widest level since mid-2010.

The two-year differential is near its best levels since then, having risen from about 2 basis points after a seemingly dovish talk by Federal Reserve Chairman Ben Bernanke near the Ides of March to 17 basis points earlier Wednesday.

7. The correlation between the euro and the S&P 500 (60-day period on percent change) has fallen nearly in half from a record high in early December of 0.85 to 0.43 in late March.

The correlation has begun stabilizing, as has the 30-day correlation. Short-term market participants should be prepared for a tighter correlation in the second quarter.

This article was republished with permission from TheStreet.

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