Euro at The Crossroads

Yet another battle royal has hit the scene. Such battles make up a long list, whether with TNote yield, S&P500 defense, gold price support, copper price breakout, bankers index defense, General Motors demise, Delphi failure, crude oil defense, natural gas or unleaded gasoline explosive moves, yen turnaround, housing index bump & run, Fanny Mae stock price, etc. My eye has been on the euro currency in the last few weeks. Since June, when the euro weakened, the gold price rallied upward. In these last few weeks, when the euro strengthens, the gold price has rallied upward. Call this a notable change in the wind direction. The gold price is consolidating in euro terms after a powerful upleg since August. The USDollar index, faulty as it is (being basically an anti-euro index) from its 1960 decade adherence to trade weights, shows as much resistance at DXY=90 and support at EURO=120, each a reflection of the other critical line. Given the profit-taking and consolidation in the gold market since the 480 level was touched a few weeks ago, we have clear identification of critical lines of defense, support, and resistance for gold. These topics are fully covered in the November Hat Trick Letter issue.

The Euro Central Bank at the end of September turned down the opportunity to cut interest rates. Some expected the ECB to cut, as FOREX professionals had sold down the euro currency in anticipation of an event which did not occur. In response to the decision of no action, the FOREX bid up the euro above 121 suddenly. For the second time since summer, the 120 level was rebuffed. Critical support has been set at 120 in a clear fashion. Back in early June, the euro was under siege from lost confidence after the French and Dutch NON votes for central power in Brussels. It was my expectation that the euro would successfully defend the 120 level in midsummer, and it did so, much to my satisfaction. The sale of truckloads of gold bullion by the ECB was used to purchase euros in that defense. So much for lost confidence. The last thing their officials want is a run on their young currency, which would force them to raise interest rates in desperation. In September it was my expectation that the USFed would herald an end to rate tightening, in view of economic slowdown and monumental hurricane relief and reconstruction. That gathering policy formation did not occur. Instead, the USFed seems to have responded to monumental irresponsibility by the USGovt administration and Congress on spending. In recent weeks, the euro has dabbled with a 119 handle. Again, FOREX experts are calling for 115, just like they did in June. My forecast is that they will be wrong once again. Curiously, US Senators are talking up a responsible reaction on spending, with cuts and more prudent appropriations to spending. Could it be that Chairman Greenspan read the riot act to certain key Administration and Congressional leaders, promising the USFed would continue upward pressure on interest rates as long as the USGovt officials were acting like adolescents with credit cards at shopping malls??? Methinks YES.

Note the favorable technicals in the euro chart. We have a double bottom being formed in a classic "W" figure. We have the 20-week and 50-week moving averages leveling off. The 20wMA should flatten very soon, as older weekly numbers are replaced to newer equal numbers. The 50wMA should gradually decline enough for a moving average crossover. The slow stochastix are within a week or two from registering a crossover, good for a lift. Relative strength is also showing improvement. In the mid-June Hat Trick Letter issue, my forecast was stated, that "the euro currency will bounce from 120 to fill the gap to reach 125.5," which it did by late August. A base has been built, despite all the talk of a stronger USDollar.

ANOTHER DEFENSE OF THE EURO
The euro has so far successfully defended the 120 level, for a second time since June. As the rising interest rate environment damages the US Economy, perceptions of USDollar strength will wane, and the rate differential favoring the USA will not offset the trade surplus advantage favoring Europe. The United States has a horrible trade gap, while the European Union has a substantial trade surplus. The result is a capital flow which favors the euro as a tail wind. The euro continues to be hurt by a rate differential, together with poor political confidence, especially after the German vote to backtrack on reforms. Germany has embraced political stalemate. The US Economy is hurt by a flat Treasury yield curve for bank centers, and by a stall in the housing market, both the predictable consequence of USFed rate tightening.

A grand battle is being waged. The USDollar rises at the expense of both the euro and yen from higher USFed directed interest rates. The euro continues to defend its critical support. The Japanese yen simply declines steadily lower toward midsummer 2004 levels. A new prevailing sentiment has arrived, that the USFed has already gone too far, and will damage the US Economy to the point that the USDollar has lost some attractiveness. Look for the 50-week moving average to level off, for the stochastix to trigger a short-term uptrend, and for the 120 level to continue to hold. That view goes counter to the FOREX consensus. They might under-estimate the damage to the US Economy which is wrought by higher short-term rates, the coerced nudged higher long-term rates, the Fed Governor chorus scare of price inflation arrival, and the undercut of the housing market. FOREX traders might believe too much in rate differential as an omnipotent force. These factors all weaken USDollar perceptions perhaps more than single-minded FOREX traders expect. They see a rate differential and little else, as an omnipotent factor. It could be that they actually believe distorted US GDP growth figures. One should constantly be aware of reversals of past carry trades, whereby borrowed money of US$ denomination is being repaid. In 2002 and 2003 and 2004, the world's speculative players almost uniformly borrowed in US$ terms. Now they are paying back those US$-based loans for massive gambles, known as carry trades.

The Homestead Investment Act to date has likely given the USDollar some boost, but it surely has not produced much in job growth. The repatriation of a reported $206 billion, when exploited, enables avoidance of a 25% tax in a splendid display of corporate welfare. A 5.25% tax is levied instead, but the federal program is hollow. The lack of profitable opportunity inside the United States cannot be relieved by favorable one-time tax advantages without promising destinations.

Officially known as the Amendment for American Jobs Creation Act, it is a failure which few seem willing to admit. Instead of creating jobs, companies do what they feel is urgent or expedient. They pay down debt, meet worker payrolls, and other operational obligations. In all, 91 companies have disclosed some repatriation, led by Pfizer, Merck, Hewlett Packard, Johnson & Johnson, and DuPont, each over $10 billion. Job creation was the theme for bill passage, a hope & dream, not a reality. The reality is that gobs of money returning, after being repatriated, are being directed toward stock buybacks in a pure sham. Is this what Congress had in mind? Is this what the Administration had in mind? Could this have been the plan all along, in support of executive stock options? It is surely to be deemed a good thing, since the financial sector is the ruling tail to lead movement for the hapless dog. The domination of the finance sector over the real economy continues… for now.

The Arabs are quietly buying gold. The trails lead from Arab gold transactions out of Turkey and Dubai, not from the Western mainstream locations like London or Frankfurt. In the 1970 decade, Arabs recycled surpluses into US Treasurys, only to suffer huge losses. They got burned badly. Harboring basic distrust, Abdullah remembers. Nowadays, the OPEC leader Saudis are talking nice to US officials, but behind our backs they are stockpiling EuroBonds and gold bullion. They have brought $230 billion home from Western banks, in a vivid display of distrust, whatever the stated reason. Granting the advertised 15% across the board pay increase within the entire Saudi Arabia society and industry cannot justify such a transfer. One should note that oil and gold no longer rise together. A new period is upon us, where gold will take the leadership role among commodities, at times held back by movement in crude oil. In recent weeks, however, a relaxation in crude oil prices has been forced by slower economic growth, by energy demand destruction, and the general growing perception that the USFed might have already gone too far in tightening on interest rates. The ease in the oil price has pulled down gold temporarily, as the markets weigh whether a recession led by higher energy costs is around the corner.

THE NEW CARRY TRADE
The carry trade pushes up the USDollar, based on a euro and yen front end. The carry trade is a monumentally powerful force in the currency world, which takes full advantage of cheap money to borrow, and higher yields to invest in, aided often by extreme leverage. Here is the blueprint on how it works. European short-term interest rates are a full 2% lower than those in the USA. So borrow cheap European money. Japanese short-term interest rates are essentially zero percent, that is right, zippo. So borrow cheap Japanese money. With these sources of borrowed money, earn 3.7% on purchased 3-month US Treasury Bills. Pocket the 1.7% disparity on euro-based "carried" loans, and the full 3.7% on "carried" yen-based loans. Thus the name.

If 3-month TBills are the vehicle, then bond risk is nil, since they can be carried to maturity. If the purchased bond is of longer maturity, then the inherent risk to carry trade participants is a loss in the principal value to the USTNote bond instrument held. If long-term (not short-term) rates rise to 5.0%, then the gain on the security will be forfeited. EuroBonds pay about 1% less than those of US variety. The vig in the rate differential will be offset, and perhaps overwhelmed by the principal loss. The other risk is with currency. The carry traders hope the euro and yen fall in exchange rate value, and the USDollar continues to rise. They are working against a massive capital flow from the trade deficit hemorrhage hurting the US Economy, and not improving. If the euro bounces off 120 and works toward 125 again this winter, the euro-based carry trade will come to a halt. If the yen currency rebounds, so will the yen-based carry trade come to a halt. The vig in the rate differential will be offset, and perhaps overwhelmed by the currency translation loss.

Despite the low profile given it, and the absent publicity it receives, carry trades are powerful. As the US short-term interest rates continue higher, the carry trade based in cheaper euro money and cheaper yen money will remain in force to aid the USDollar. Recall that there has been a disconnect between short-term and long-term US-based interest rates, the phenomenon dubbed the "conundrum." However, rising rates will coincide with a rising gold price, since gold will be on the investment side of the equation also. One can used borrowed (carried) loans to purchase gold as well, using asset gains rather than yield differentials to generate profit. A gold carry trade has arrived in Europe and Asia, powered by the same cheap money source. My expectation of a faltering USDollar has not come to be. The mindless USFed rate hikes have supported the US$ from bond speculation via carry trade and rate arbitrage. The USFed has gone too far, with a US$ exchange rate the beneficiary. Some bigtime lies will be necessary to sell a positive spin on economic growth, as measured by the GDP statistic.

THE NEXT STAGE
The euro will continue repeated tests at the 120 level. On a technical basis, an uplift has been seen. Lately, as the euro has relaxed, gold has come down. Lately, as the euro has bounced, gold has been lifted, the opposite of the early summer trend change. As the USFed continues its rate hikes, the new perception might quickly take over and supplant the consensus. The US Economy will slow from higher borrowing costs, from removal of easy finance deals for consumer purchases, from higher mortgage adjustable rates, from double the usual credit card payments, and more. The impact on the USDollar is certainly going to be negative, at a time when higher energy costs are causing pain both to households and to businesses. Beneficial interest rate differentials can only support the USDollar only so much. Eventually the trade gap becomes a major issue. The down side to this US$ lift in recent weeks will be the continuation of the capital flow hemorrhage in the trade deficit, with monthly tabs over $50 billion.

Look for any clear breakdown below the euro 120 level. A mere 119 handle on a print is not sufficient to break the euro chart. A breakdown requires a 118 print for a few days. Then come the stop loss sales which send it down lower. The bearish Head & Shoulder pattern indicates a potential total retracement of the euro back to 105. The calculus is easy. The peak high of 135, the neckline at 120, thus a 15 point potential swing. From the 120 neckline, subtract 15 to get 105 as a target.

My personal view and hunch is that FOREX will not permit a euro breakdown. We now stand above 121 on the euro versus the US$. The US Economic fundamentals are simply too horrendous. Capital flows of over $50 billion on a monthly basis are too difficult to offset with bond speculation. It is like leaning into Hurricane Wilma and hoping to remain standing. The 100 mile-per-hour winds are stiff. Eventually the leaning body is blown to the ground, clothes disheveled if not removed altogether. Imagine an Uncle Sam, with withered ramparts from debt addiction, with stick legs from absent manufacturing base, with a nosebleed from arrogant nose propping, with some bullets lodged in his backside from an endless war. His absent blood supply from a decade of hemorrhage has reduced his body weight. Poor Uncle Sam cannot withstand the harsh winds of capital flow. The "leaning" from attractive higher interest rates cannot work for long. And yes, all those liver spots and blisters on his craggy skin are the after effects of a series of bubbles. Or is it skin cancer?

One cannot overlook the announcement of Ben Bernanke as Chairman Greenspan's successor. As colorful Jim Jubak states, "the initial bounce to the US stock market might have been due to relief that President Bush did not appoint somebody like his personal stock broker to the post." The after-glow seems to be a selloff to the USDollar (with a rise in the euro) and a simultaneous demand for higher long-term interest rates, as in a selloff to US Treasury Bonds. On Tuesday, we saw a 130 basis point rise in the euro. That is a significant vote of no confidence in the next US central bank chairman by Europeans. Gold rose over $7 on Tuesday in response. Winds are changing once again.

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Jim Willie CB is a statistical analyst in marketing research and retail forecasting. He holds a PhD in Statistics. His career has stretched over 23 years. He aspires to thrive in the financial editor world, unencumbered by the limitations of economic credentials. Visit his free website to find articles from topflight authors at www.GoldenJackass.com.