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MARKET INSIGHT REPORT Trees Dont Grow to Heaven By John R Taylor, Jr. Chief Investment Officer At some point in every mass social phenomenon, the participants involved reach the point where the trend overwhelms everything else and rational judgment loses out to emotion. The most famous example is the Dutch tulip bulb craze, but the tech bubble in late 99 and early 2000 would seem as good an example. These emotional over-shoots happen all the time on a smaller scale, but the bigger the scale the larger the irrational pricing beyond the fundamental realities. This desire to follow the crowd is what makes trend-following successful when it is impossible to understand the basis for the price of an instrument, the best thing to do is follow others whoever they are and whatever their reason who have already committed to the price. We refer to this conceptually as model uncertainty: when the historic references no longer apply, the only benchmark you can find to protect your investment and your job is to do what the others are doing.
Right now the crowd is borrowing the US dollar or selling it outright. Among the vehicles that have looked especially attractive for expressing this view are peripheral debt instruments within the euro-block. If the euro is to continue in its present form through the investment horizon, then buying Spanish or Irish government bonds would seem a very good bet they pay more than other euro investments and they are euro- denominated. Ever since the last days of November 2011, a very dark time for the European dream, when the European Union, the ECB and the several dominant countries showed their willingness and their ability to unset powerful political figures who could upset their program, the European sovereign debt market has rallied relative to the dollar bond market and those of the rest of the world. Since the removal of Berlusconi, no other prominent leader has voiced any disagreement with the German-led program. In July 2012, when Mario Draghi sharpened the issue by focusing on the immediate problem of the euro and stating forcefully that the ECB had the tools and would act strongly to do whatever it took to save the euro, the game changed completely. Not only would recalcitrant leaders be forced to acquiesce or else, but there would be no doubt of the euros survival. When it became possible to buy euro securities with both a high yield and a currency that was controlled by Germans or German-like institutions, they sold like hot cakes. Actually, it took quite a few months and a track record of great performance before the trend became so obvious that everyone wanted to join it. The pendulum has swung so far that governments within the Eurozone with debt loads of over 100%, very high tax loads and government participation in the economy, no economic growth, and no inflation can borrow at rates below countries like Canada, Australia, and New Zealand whose economies and demographies are dramatically superior to even the best Eurozone country. Within Europe the spread between Germany and Spain is still dropping, but it is the market strength of these weak economies versus the US and other outside markets that shock and drive the global market to its current extremes. The French 5-year rate is below the US by 84 basis points, while Spanish and Italian rates are roughly equal to those in the US. Because there is a clear difference in the credit quality between Germany and the others, the German market is being driven to irrationally low levels by this global desire to participate in the peripheral credit market rally. In turn, richly priced peripheral bonds impact bond prices everywhere pushing the global bond market higher. This tree is already pretty close to heaven and when Draghi cuts rates on June 5, it will touch it. With deposit rates below zero, German rates cant fall further and the peripheral rally will fail. Spreads will soon widen and the euro will begin to fall. FX CONCEPTS FX CONCEPTS GLOBAL MACRO RESEARCH GLOBAL MACRO RESEARCH CURRENCIES INTEREST RATES EQUITIES COMMODITIES To contact FX CONCEPTS New York: 1 (212) 554-6830; London: +44 20 7213 9600; Singapore: (65) 67352898; research@fx-concepts.com
CURRENCY Europe Long-Term View
Euro-phoria By John R. Taylor, Jr.
Recently we have noted that the 10-year Bonds of some highly rated countries have been yielding significantly more than those of Italy and Spain. We have nothing against those two countries, in fact we find them great places full of wonderful people, but to us their economies are not doing well and they are facing significant financial risks in the years ahead. Why would someone buy Italian 10-year paper when Australian 10-year paper has been yielding 70 to 90 basis points more?
At some point this wonderful European bond market rally is going to come to an end, and our cycles say it should have happened already. The chart to the right shows the spread between French 5-year sovereign paper and US 5-year Notes since the first half of 2011. The French premium has been as high as 1.88% just at the time the European authorities forced Berlusconi to step down as Prime Minister. To the current low spread, which has US yields 84 basis points above the French ones. This trend should be over. Our cycles argue the low should have been in the second week of March and we see a re-test of our projected low in the first week of July. It is possible this will be the final low for this re-rating of US-French risk. We have chosen France as the market to compare with the US, as it is obvious to almost everyone that the French economy is doing poorly even though it is in no immediate financial predicament. Looking at this historically, French yields have almost never been this low relative to the US. Only during the 2005-2006 timeframe, when the euro project seemed to be running so well and the world was in the middle of the Great Moderation and back in the period between 1997 and 2000 when everyone and her brother were euphoric about the coming of the euro. One would think 15 years later we would be a bit wiser, but we are not.
The currency chart shows the US dollar relative to the euro that is inverted from the normal picture. The dollar rallied from the end of August 2011 to the following July when Draghi gave his well-do-everything-to-save-the-euro speech. Since then the USD has been declining and the EUR/USD has been rallying. There was an intermediate dollar high last July and the downtrend from that high has just been broken, which is apparent on the chart. That level for the EUR/USD is the 1.3790 level and we are expecting a drop to the 1.3580 area at the end of next week or in the week of May 26. We are also expecting another attempt to the downside for the USD into the end of June or the start of July. That could possibly see a new USD low, coinciding with a higher level of euphoria about euro assets. Our analysis argues very strongly that French and peripheral hopes will be dashed and the EUR/USD will decline back through the 1.33 to 1.34 level and eventually into the 1.20s, probably by year-end.