Euromesia: Decoupling is mainstream, again.

• RemixTrades
• August 3rd, 2010

Amnesia is taking over currency markets again as the recently disliked Euro-US Dollar ($EURUSD) has now become the currency cross to buy. All it took were some lackluster ‘stress tests’ to convince investors (or maybe the media?) that everything in Europe is fine; stress tests that don’t even take into consideration a sovereign default (i.e. the possible event that made global markets breakdown in the last few months).

The Euro-US dollar has rallied relentlessly since touching the 1.18 handle. It has broken through the key levels of 1.27 and 1.30 without hesitation and is now attempting to break through the 1.32 zone. On the surface, one would believe that the Euro is rallying because Europe solved its problems sometime overnight in the last few weeks. However, as many suspect, a “problem solved” attitude  may not be the only factor moving the single currency. While recent European economic data is fueling bullish sentiment and a short squeeze killed some bears, the Euribor rate (i.e. the overnight interbank lending rate for European banks) and the decoupling psychology behind the Euro rally have likely been the main drivers of the single currency rally.

Positive European Data

“Soft” economic data from the United States combined with better-than-expected data from Europe has caused the idea of ‘de-coupling’ to resurface once again. It’s interesting to see how two months of volatile and widely unreliable (as in margin of error) data points have put all of the financial media pointing to a possible decoupling.

Let’s take the time machine back to November 2009. The Euro-US dollar was above 1.50 and the dollar index was inching towards the 74 level. The standard media hype was that the market was expecting Europe to decouple from the United States and outperform. The US dollar was near imminent collapse and ready to lose its safe haven status.

Fast forward one month to December 2009, without any mention of Greece and the likes, and the US dollar was targeting the 80 level on positive economic data and the expectation of a rate hike by the Federal Reserve. The idea of decoupling was also fading. As is common, the lag in European data relative to the United States was catching up. Overall, this caused the Dollar Index ($USDX) to reach the 80 zone on what I’ll call “organic” reasons (i.e. not safe haven or panic reasons).

It is true that the Dollar Index does not currently belong at the 88 and 89 levels. Those are panic levels. However, at the 80-81 “organic” level, I would expect the US dollar to maintain some strength and the Euro to stay in a range before the decoupling idea probably starts to fade again.

Investors, or more precisely the media, seem to forget that the present world is largely globalized. As a result, the belief that the US can slow down substantially while the rest of the developed and widely interlinked world continues on happy growth is largely unimaginable. The recent “Great Recession” is a great of example of what happens when things go haywire in the place where core global demand originates. And don’t think ‘China demand’ or something similar would be able to pick up the slack. It would take years, if not decades, for China or any other country to have the same global impact as the United States.

In general, the positive European data is likely to be short-lived as it catches up to the US data.

Euribor

Currency traders, the media, and the experts on CNBC all seem to believe that the stress tests were enough to confirm the solvency of European banks, except for the banks themselves. Even though they won’t publicly admit it, the banks know they would be doomed if a major European sovereign default occurred. And they’re also pretty sure that it would affect more than just their trading books.

I haven’t talked to any banks, but the benchmark 3 month Euribor tells the story. Ever since the stress tests, the rate has continued to stay near the 0.9% level. Overall, the relief seen in the equity and currency markets did not funnel itself into the banks themselves. I would suspect they know something that others don’t.

The unwillingness to lend by banks creates a factor that may also be influencing the current Euro rally. As banks keep their Euros, there is a shortage of the currency for funding. This increases Euro demand relative to supply and a funding squeeze occurs. While the Euro was oversold in the near-term, this possibility is also plausible in partially explaining the recent Euro rally from 1.18 to 1.31.

Psychology

It seems like ‘media experts’ have already decided that Europe will likely be decoupling from the United States slow down, again. What I call the “Euro 1.52 sentiment” is taking over. This is evident by the number of articles in the financial media hinting that the ‘dump the dollar, buy the Euro’ attitude is re-emerging.

The Big Euro Squeeze is burning a lot of bears and putting the bulls in the spotlight. Nevertheless, the thing to remember is that big reversals have occurred the last few times this type of Euro euphoria took place. Optimistic yet erroneous psychology can move the market in the wrong direction only for so long. When the European data catches up to the US data, King Dollar will likely have its time to shine.

In sum, the macro picture for the Euro bodes well for a range period. Positive European data is likely to push the Euro currency slightly higher and then down as the data catches up to the United States. Additionally, as long as the Euribor stays elevated, there will likely be a strong support for the Euro-US dollar cross.

Lastly, be aware that while amnesia can take over, memories do often re-emerge. And when they do, it scares everyone just like before.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

Tickers: $EURUSD, $USDX

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