Tuesday, 5 August 2014

Will The EURUSD Be Influenced by Last Week's Numbers?

The US labor numbers released Friday showed the US economy is gradually creating more jobs.  The July number - 209K - did fall short of higher expectations from the bulls, but was still a respectable number.  The unemployment rate went up to 6.2%, a mere .01% higher, which reflected a small increase in those seeking a job.  Still, the U-6 number which measures those unemployed, and working part-time because full-time jobs are unavailable, is 12.1%.  This U-6 number equates to 23.8M, and perhaps illustrates the slack in the US labor markets, which hinders wage increases.

The markets were apprehensive because superb NFP numbers would hasten the day the Fed would increase rates; this fear was not justified.  The 10-year US Treasuries shed five basis points taking the yield back near the 2.50% area.  While the US numbers are sufficient for the Fed's taper to continue, the fear of a rate increase has diminished.

Fed Chairman Yellen's concern for the the tepid labor market will certainly continue, but giving the Fed the responsibility for achieving full employment is really a "mission impossible."  It is small business, rather than monetary policy, which is needed to stimulate job and vibrant economic growth.  US small business formation has been squelched by the massive growth of laws and regulations imposed from Washington; these are in addition to the costly, confusing and ever-changing Affordable Care Act.  To start and succeed with a new business, a costly battalion of lawyers and accountants is needed to complement a strong business plan.

Large US companies are better staffed and able to comply with the ever-growing myriad of regulations, however, the tax burden for US business is probably the world's mosr draconian.  The combination of the highest Federal corporate tax rate, plus state taxes will take the combined tax rate over 40%.  No surprise, then, the large US companies are threatening to relocate off shore.  At the same time, the US government is trying to legislate laws that obstruct these relocations.

Despite these hindrances, the US economy, if we are to believe the initial GDP estimate, grew at 4% in 2Q.  I suspect there will be some downward adjustments in the next few reports.  For the equity markets, the good news was negative.  Those markets are already fretting about what will happen when the Fed is no longer injecting billions, monthly, into the economy. 

Considering these self-imposed obstructions, it is surprising the US economy has fared this well.  Deficit spending might be a major reason.  In January 2009 the total US sovereign debt was $9.2 Trillion.  Now, toward the end of this fiscal year 2014, the US debt is approaching $18T.  In a macro sense, this is $9T of spending.  Even if there was no Keynesian multiplier effect, this spending still had to contribute immensely to the US economic activity.  Over the next few quarters we will find out if the US economy has the ability to grow despite a reduction in the monetary stimulus, and a possible contraction of the fiscal stimulant.

In foreign exchange markets, currencies are measured against other currencies in various ways.  Relative economic growth is one yard stick.  Here, the US economy is now exceeding the EU and Japan.  Lagging growth in the EU and Japan is then partially responsible for the expanding money supply in those countries compared to the hint of smaller monetary growth in the US. 

Interest rate differentials are now favoring the US.  Currently, the ten-year rate is a mere .53% in Japan, 1.13% for German bonds, 1.51% for French bonds, 2.55% for Spanish and 2.76% for Italian.  As mentioned earlier, the US 10-year yields around 2.5%.  At this time last year, the yield on US 10-years was about the same but the yield on Italian bonds was 4.45%, and Spanish bonds were 4.66%.  The global search for bond yield last year took all the risk premium from the Spanish and Italian bonds.  To acquire these bonds, those buyers from outside the EU had tao also be persistent buyers of the euro which may have been one of the reasons the euro was stronger than warranted,

So, and at the current rate differences, it would seem some of the bond buyers in Spain and Italy may take some profits and move the money elsewhere.  With the winds of war, at least a cold and trade war at Europe's Eastern borders, this seems prudent.  There are also hints of commercial bond defaults in Portugal and Spain which may concern the owners of Southern European bonds.  Finally, the French economy remains the sickest in Europe.  Who wants to own the French bonds that yield only 1.51%?

The macro reasons for the euro weakness are abundant.  The question then remains, how much of this has been priced into the market?  Looking at the daily chart, it is obvious there has been heavy selling pressure.  The COT report dated July 29th 2014 confirms this.  It shows the total open interest of futures and delta adjusted options has soared to 420,808 contracts.  Each contract is for €125,000 worth about $167,762 based on the close.  Combined speculators are short a record 157,216 contracts, up from 132,099 last week.  Since the total spec short in the euro futures is approaching $2.8 Trillion dollar, this trade is no secret.

Click to Enlarge EURUSD Daily Currency Chart

Market action in the EURUSD (FXE, UUP, UDN) on Friday might have been a warning for the bears.  The market did not make a new low, and then engulfed the two previous sessions to close near the high.  Markets do not discount the news more than once.  Should we avoid more bear news over the weekend, we may be headed for a bit of a relief rally in the euro.  However, if the geopolitical tension with Russia worsens, or if there are more reports of European bank troubles, these troubles might provoke more selling.  Eventually we may be headed for 1.30 or lower in the EURUSD, but markets rarely do what everyone is expecting.

Click to Enlarge EURUSD Weekly Currency Chart

Technically, the weekly chart is signaling a possible turn around.  The action for the week is a doji, with the closing price on the 200 week SMA.  The news remains bearish but the technicals suggest we should beware of potential changes in the market's direction.

Ralph Shell, Excel Analyst
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