Mile High Insights
The Euro-Rocket will burn out
The Euro-Zone Consumer Price Index (CPI) for March climbed by +3.6%. This constitutes a near 16-year high and was higher than the initial estimate of +3.5% and the +3.3% figure in February. European food prices rose in March by 6.2% compared to last year, which represents an acceleration from 5.8% in February, which itself was a record for the series that goes back to 1997. Energy prices rose by 11.2% from +10.4% in February. The Euro-Zone core CPI rose to +2.0% from +1.8% in February. The German March CPI rose to +3.3% from +2.9% in February. No sooner were the numbers released than the Euro rose to a new all-time high. The reasoning was that the European Central bank was unlikely to lower interest rates, when inflation was climbing to a new 10 year high. The dollar index in turn collapsed on the news. The difference was that this time the index did not make a new low although the Euro reached a new high. Take a look.
The Euro is clearly the strongest of the four currencies. In fact it is taking off like a rocket. I included three trend lines in the chart, each with a successively steeper angle. How much longer can the Euro climb like that?
A week, a month? I believe that the Euro has almost reached its apex. If you look at the other major currencies, you will see that they have peaked some months ago. The Australian dollar is the strongest and could not make a new high today, when the Euro was exploding to the upside. You will have to take my word for it but almost half of all major currencies have already peaked against the dollar. What this tells me is that the strength of the Euro is no longer derived from dollar weakness but that it is driven by emotion and “Euro-Mania”. I think it’s only a matter of weeks before the Euro will top out as well. I am telling you this because these currency developments and/or reversals will be part of a bigger change in interest rate regimes, in commodities and in stock sector performance. The prevailing trend in interest rates has been down ever since the sub-prime crisis hit the markets in July of 2007. Interest rates peaked in mid-June and have been declining ever since, as the flight to safety depressed yields all over the government securities spectrum. At the same time the dollar fell like a stone based on the correct assumption that the Fed would have to combat the crisis by lowering interest rates. The stock market in turn fell along with yields based on the threat of recession and fallout from the banking crisis.
The left chart shows the fall in 10-year T-Note yields and compares it to the performance of the S&P; 500 since June 15, 2007. You can see that since that time, both have declined more or less in tandem. The right chart shows the performance of the Euro and crude oil (West Texas Intermediate) since January 2004. Since 2007 both have moved in lockstep also. Whatever the reason for the parallel moves between the Euro and oil may be, the fact is that if the Euro reverses, I bet money (customers money and my own) that it will be caused by or be the cause for a reversal in crude oil also. Which of the two will be the cause for the other really does not matter to me at this point in time. The correlation is strong enough for me to believe that it will continue throughout a reversal. Falling oil prices will take pressure of the economy and a rising dollar tends to be associated with a strengthening financial system. That would constitute a complete turnaround for many sectors. The weakest stock sector so far was the financial sector. They were losing Billions in sub-prime derivatives and some of them already went under. Some blame the mark to market accounting rules for this, which is of course utter nonsense. These rules forced banks to adjust the value Billions and Billions of complex structured products downward to the last trade of the month or of the quarter. The last trade of the month in an illiquid market, where everybody wants to sell and nobody wants to buy, can mean that several $ Billion worth of product have to be valued based on a trade of $1 Million or less. To hedge their exposure, the two dozen largest banks in the world had created the consortium “Markit”. The consortium facilitated the trading of index products to allow the hedging of asset backed securities. The problem again was, everybody tried to hedge but nobody wanted to speculate on the other side. Again, sellers overwhelmed buyers and the result was an extremely depressed index. Everybody in the industry now had the choice of two bad alternatives. You either took the actual market of your product as a benchmark or you took the indices as benchmark. Either way, banks would have to mark their portfolios to extremely low prices. Jack Welch said yesterday on CNBC that he believed that once we surface at the other end of this, many write-offs could turn into write-ups. This has become an essential ingredient of my current investment strategy. I do not want to oversimplify the fact that the worldwide de-leveraging process is still underway and that there are of course valid reasons, why mark to market was put in place to begin with. I also know that many of the original assumptions about defaulting homeowners were false or overly optimistic. Nevertheless, I believe that regional banks provide a good hunting ground for artificially depressed stocks. There are certain sectors that the public has fallen in love with: Energy, global engineering, agriculture and fertilizer and then there is one sector that is universally hated: the banks. For the current earnings season, I much prefer the exposure to the expected bad news from the banks than the “not good enough” good news from the energy sector. I am also betting on a trend change. I am not exactly sure if we will see a permanent trend change or just a temporary one. But I am convinced that we are looking at a multi-month correction in currencies and commodities at the very least. This also should benefit the financial sector.