The EUR/USD Remains a Buy on Dips

Lately we have pointed to a number of issues regarding the EUR and the USD. Over the past few days, we have worked on a predictor of the EUR/USD price based off a number of inputs; namely the European/US 2-Year Basis Swap (a measure of US vs. European interbank credit quality); the interest rate differential between Europe and the US in the 2-Year swap rates; the level of the CRB Index (a broad basket of commodities); and lastly the price of Gold as a function of the USD Index. Our analysis supports our view that the EUR is undervalued relative to the USD, currently indicating an undervaluation of about 16 percent. Much of this undervaluation comes as a consequence of the dollar's “flight to safety” status, a status we have lately questioned. The latest move lower in the EUR/USD came as the flight to safety trade was added to on fears over imminent Euro collapse brought on by news out of Ireland and Portugal. See Chart 1.

Our reasons for why we like the EUR/USD are numerous. First, we see continued demand from Asian Central Banks to buy EUR in order to diversify out of their overly long USD foreign exchange reserves. Secondly, we are growing more concerned over state and local weakness in the municipal sector. Be it in California, New York or Illinois, the daily headlines concerning fiscal and pension deficits are increasingly alarming, especially given the only way out is through bail-outs or economic growth, and given the latest data on housing and employment we do not see the latter as the near-term outcome. Recent squabbling in the Congress over the inclusion of the Build America Bonds program in the latest tax deal is sweeping the only support for the municipal sector from under its feet.

In no way do we see the Build America Bonds program as a panacea for what ills Municipals, rather we see it as the duct tape holding states together until growth in whatever guise comes its way. With no growth and no duct tape, we see the problems of state and local governments coming to the fore. Given California, New York, and Illinois comprise 25 percent of the US GDP, we believe headlines regarding their budget deficits will soon overtake those regarding Ireland, a country that makes up only 1.8 percent of Euro-Zone GDP.

We have often talked of how economic divergences are causing the European Union to diverge with the wealthier countries, which benefit from a lower EUR/USD, pointing to weakness in the peripheral countries ─ something that helps lower the EUR/USD and so allows the wealthier countries to export more. Certainly Germany and France are in this camp, with each country's leader threatening to leave the EUR/USD over the past 8 months, France in May and Germany in October. Of course, leaving the EUR would be a disaster for each country, given the impact on their exports.

Perceived weakness of the peripherals leads to weakness in the EUR/USD, in turn driving French and German exports and growth higher. If Germany and France returned to the Deutsch-mark and the Franc, we can be assured that their currencies would strengthen significantly overnight, choking off any and all exports. In addition German exporters would leave Germany and open in Spain, Portugal or Ireland, where the cost of labor would be lower, and the local currency much weaker and so better suited for trade. Japan faces the same issue currently, as its exporters threaten to leave Japan to set up shop in China and Korea whenever the JPY strengthens too much versus its neighbors.

The market will soon realize that the ECB will stabilize European periphery markets at all costs. The cost to Germany of a fail in the German banking system is much greater than the cost of shoring up the peripherals. Both Chancellor Merkel and President Sarkozy admit this, however, this is hardly the simplest concept to sell to their constituents, who see it as bailing out failed governments and shoring up the European banking system, both of which leave a bad taste in the mouths of German and French voters.

In the US, we believe when troubled States come to Washington for aid going forward they will meet with a less understanding Congress. The Tea Party looks unlikely to approve bail-outs for individual states and pension funds. The Tea Party is the US's version of France and Germany; unwilling to help those in fiscal trouble because it is not the fiscally responsible thing to do. The deadlock implied here will leave it to the US Federal Reserve Bank to come to the rescue. A number of FED speakers have stated that the goals of QE2 are to boost asset prices, specifically housing and equity prices.

Higher housing prices help state and local governments because they protect real-estate tax revenues. In addition they have a wealth affect for voters because they make the owner feel wealthier. Higher equity prices help out State and Local governments because they inflate pension funds assets, and so reduce deficits in these programs. A few days ago the New York State Pension Plan noted that it had a 70 Bio USD deficit. This can be fixed by topping up, borrowing or by inflating equity and asset prices. The Tea Party will not top it up. Borrowing will become more expensive without the Build America Bonds program, and so the FED will inflate asset prices. Higher equity prices also contribute to the wealth affect. The individual gains confidence when their equity investments and 401Ks are higher.

Inflation of asset prices, the object of QE2, comes at a price and this is the problem for the USD. We can see the issue when we look at the tremendous moves in commodity prices over the past year. Quantitative easing has yet to help housing or equity prices, however it has resulted in higher commodity prices specifically because investors know that if the price of their home and equities is being forced higher, then so is the cost of their purchases. Food stuffs become more expensive as does energy. Gold and silver have seen significant rallies, and we believe this is only the beginning. The Fed aims for 2 percent inflation as measured through the CPI, and will continue their asset purchases until they see results in the CPI. At the moment their efforts if anything are only stabilizing downward price moves, and have yet to result in positive momentum in the CPI. When positive momentum comes we expect significant rallies in the commodity sector.

Finally, the US Senate continues to press for a stronger CNY against the USD, with Senator Kerry yesterday suggesting the Senate may pass legislation on China currency. We have often said that the CNY can only strengthen against the USD if the EUR/USD goes higher. From 2005 to 2008 when the CNY was last “flexible”, USD/CNY and the USD/Index moved in lock step. China is under pressure to strengthen the CNY, specifically before the US/China State dinner in January, and also ahead of any Senate vote. Internally a stronger CNY helps combat inflation. We expect China will soon be very vocal in showing support for the EUR/USD, and expect their purchases of EUR/USD will increase dramatically over the next few weeks.

In short, we believe the stabilization of Europe will come shortly. This will be followed by significant USD selling and EUR buying by Asian Central Banks. Commodity prices will continue to rise against the USD as US internal weakness is exposed by the ending of the Build America Bonds program. Our predictor sees the EUR/USD as currently 16 percent undervalued using traditional valuation measures. European issues have been in the headlines as of late, but we believe we will be reading about US issues and Chinese CNY strength going forward.

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