Wednesday, July 18, 2012

the euro

Here is a month chart showing the Euro priced in dollars for the past 15 years. Since events in Europe have had so much impact on the US stock market over the past few years I thought it would be interesting to see what we can infer about the economic prospects in Europe from the long term trend of the euro currency .

The  first obvious thing I see in this chart is the beginning of a long term downtrend which I have highlighted with a red trend channel. The euro has spent most of the last five years trading between 1.24 and 1.61. I think it has begun to sag downward out of this trading range recently. The next trading range can then be projected to be the same size as the first with its high at 1.24 and its low at 0.87 (blue dash rectangles).

A drop to the low of the second projected range would represent nearly a 50% depreciation of the Euro. What economic events would be consistent with such a depreciation?

The first thing which I think a long bear market in the Euro implies is that short term interest rates in the EU will on average be below those in the US and that over the next few years this difference will widen. Such an interest rate gap would result in Euro which drops against the dollar. This in turn tells me that the EU economy will be weaker and grow more slowly than the US economy over the next few years - this because lower short term interest rates are associated with lower economic growth.

The second thing a bear market in the Euro implies is a process of more quantitative easing in the EU than in the US, probably because the very same economic weakness arising from  relative low short term rates would also be accompanied by EU banking system solvency problems as well as potential sovereign bond defaults.

Sub-par economic performance  in the EU is not exactly a plus for the US stock market. Even so, I think that a down trend in the Euro necessarily forecasts an improvement in the US economy which would raise short term US interest rates visibly above European ones.

We have seen three successive EU-scares in the US stock market over the past three years. This year's has been the mildest of the three, so I think that investors in the US stock market have pretty much discounted the worst that is likely to occur in the EU. Coupling this with a slowly strengthening US economy makes me think that earnings of US companies will exceed expectations over the next 12 months. This is a recipe for higher stock prices in the US.


mike said...

thanks for the update carl. so..where does that leave the 3 peaks and doomed house pattern? a strong US market over the next 12 months seems to conflict with the doomed house pattern playing out.. thoughts?

Carl Futia said...

no. Good earnings over the next 12 months need not imply more than a few months more of rising stock prices.