Euro Bear Trend is Just Beginning

-Technical argument for the EURUSD to fall below parity…and lower
-The meat of the decline is just around the corner
-Fundamental justification for an incredible EURUSD decline

Technical Argument: Jamie Saettele

[B]Euro / US Dollar[/B]

Dating to 1971 (prior to the creation of the Euro, data is synthetic EURUSD rates…mostly DM rates), the EURUSD has exhibited a distinct rhythm of rallying for roughly a decade and falling for a little more than half a decade. The pattern has completed 2 full cycles and the first half of the 3rd cycle (up-down, up-down, up-). If the cycle holds, then the EURUSD decline has much more to go. Also, notice the outside candle patterns at the top in 1980 and 2008.

The wave structure supports the long term cyclical behavior. The Wave Principle is model of how markets behave. There are 2 basic types of waves; impulses (5 waves) and corrections. Within the correction category, there are triangles, zigzags, and flats. Flats also fall into a number of categories. One particular type of flat is an expanded flat, where wave B exceeds the origin of wave A and wave C completes the pattern below the origin of wave B. Since 1995, the EURUSD has followed the expanded flat model perfectly. The pair is in the early stages of wave iii of C (usually the strongest wave). The implications are extremely bearish as the pattern is expected to complete below .8225. It is difficult to say how long it will take for wave C to complete but we can make an educated guess. Wave A took a Fibonacci 5 years and wave C should be steeper so the decline should take less than 5 years (perhaps a Fibonacci 3 years…that would place a bottom in 2010). Nearly a year has already passed since wave C began and the meat of the decline, in wave iii, is just around the corner. Also, much of the time will be taken up in wave iv probably late this year and / or in 2010.

Waves 1 and 2 of C, and waves i and ii of 3 of C are visible on the daily (notice how impulses channel). Staying beneath the April 13th high of 1.34 keeps wave iii of 3 underway towards much lower levels. 1.34, which is the risk level, is 3% from current price (1.30). The ultimate objective, below .8225, is over 37% from current price (a 37% drop from 1.30 is .8225…the target is below .8225). Note: The 55 and 200 day SMAs are on this chart and are bearish as well (55 < 200 day and 200 day slope < 0).

Please keep in mind that forecasting is a probabilistic exercise. I see the outcome that I have described as having the highest probability at this point. Again, a rally above 1.34 (while unexpected) would require a reassessment of the picture.

Fundamental Justification: Ilya Spivak

[B]Trends in Risk Appetite Put Downward Pressure on Euro / US Dollar [/B]

Recent months have seen EURUSD exhibit a very strong correlation with trends in risk appetite. Indeed, the pair’s correlation with the MSCI World Stock Index (a composite metric tracking global stock performance) now stands at a formidable 88.4%. As global demand weakened, expectations of dour earnings weighed on stock markets and pushed traders to pull capital from equities and other risky assets to seek safe haven in the greenback: the US continues to have the deepest, most developed capital markets and the most stable geopolitical profile, making dollar-based assets the venue of choice for risk-averse investors. Further, the Dollar was the “least bad” play in a global recession scenario because US policy makers were first to cut rates and introduce fiscal measures to stimulate the economy, suggesting the US will lead in the eventual recovery.

[B]MSCI World Stock Index vs. EURUSD (72-Week Rolling Correlation)[/B]

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There are substantial reasons conclude that safety-driven demand for the US Dollar will continue in the near term. While economic forecasts from central banks, financial institutions and international bodies like the World Bank do not necessarily agree on the minute details of their 2009 growth forecasts, the overall picture is decidedly grim. The International Monetary Fund has been particularly explicit, calling for the worst contraction in global output since World War II. This bodes ill for demand and will almost certainly be reflected in disappointing earnings reports, keeping downward pressure on stock exchanges across the world.

Further, as we initially noted in late March, the MSCI World Stock Index has been confined in a falling channel since October of last year. The downward slope argues for a bearish bias on risky assets for the time being with prices showing signs of reversal at the upper boundary following a corrective rally, opening the door for a move to new lows in the weeks and months ahead.

[B]MSCI World Stock Index (Daily)[/B]

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[B]Interest Rate Expectations Favor Euro Weakness Against the US Dollar[/B]

Taking risk aversion out of the picture, the case for EURUSD losses still looks compelling. The latest economic forecasts reveal expectations that US economic growth will outpace that of the Euro Zone by the second quarter of this year, with differentials remaining in favor of the States into 2010. This suggests that the US Federal Reserve will lead the European Central Bank in starting to raise interest rates to rein inflationary pressure from the massive liquidity injections seen in recent months.

Further, the US government is almost certain to issue billions in Treasury bonds to finance the tremendous amount of deficit spending that has been undertaken to combat the crisis. This flood of government debt will send Treasury prices lower and put substantial upward pressure at the long end of the yield curve. The US fiscal effort dwarfs anything that has been undertaken in the Euro Zone thus far, suggesting yields on US government bonds will see a far greater boost from new debt issuance and thereby become more attractive to investors than their European counterparts. All told, this scenario amounts to higher short- and long-term yields on dollar-denominated assets at the expense of their Euro-based equivalents, pushing EURUSD lower.

[B]Political Tension Inside the Euro Zone Threatens the Single Currency[/B]

Economics aside, the Euro also faces significant threats from mounting political tension. The European Central Bank’s has notably parted ways with major counterparts in the US, UK and Japan by opting for a “measured approach” to monetary stimulus despite deepening recession and a credible deflationary threat. Indeed, the latest data shows the economy shrank by a record -1.6% in the fourth quarter of last year while annual inflation has slowed to just 0.6%, the lowest since the introduction of the single currency. This is drawing increasing accusations of inadequacy, a trend that is sure to be amplified by rising unemployment levels as the crisis wears on. ECB President Jean-Claude Trichet’s clearly defensive rhetoric is not helping matters, legitimizing calls across grumbling electorates to free national monetary capabilities from the ECB’s lackadaisical posture. Clearly, this threatens the very existence of currency union itself if politicians eager to be re-elected succumb to populist pressure. At this point, the central bank delayed the day of reckoning by promising a final decision on quantitative easing when rates are announced in May – if that summit sees more waffling, the Euro could succumb to a significant acceleration in selling pressure as traders price in a longer path to recovery as well as the political implications of inaction.