Further Decline Likely as Woes Surround the Euro

Wednesday, 20 Aug 2014 08:00 AM

By Ashish Advani

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The euro appears to be in deep trouble.

The currency that is common to 18 of the 28 countries that form the European Union (EU) can't seem to do anything right. This isn't a huge surprise because the one official who should be its biggest proponent, the head of the European Central Bank (ECB), is the one ensuring it declines in value.

The euro was once touted as the potential replacement to the U.S. dollar as the reserve currency of the world.

While it is still a contender, it has certainly lost a lot of its sheen in the past few years. The internal squabbling of the various countries has ensured that it stays in a perpetual quagmire and never gains the world status it richly deserved.

We have seen the "currency wars" heat up. Currency War refers to each country trying its best to devalue its currency as quickly as possible to enable the country export more as its products become cheaper to the importer in relative terms. But when all countries try and devalue at the same time, it just becomes a race to the ugly bottom at breakneck speed.

No one benefits and everyone loses.

We have all heard of the debasement that the United States has done to the dollar with the quantitative easing (QE) that the Federal Reserve carried out to "rescue" our country. This is far from what is happening.

The tsunami of problems this reckless policy has created has yet to be unleashed. But the United States has been very critical of the EU, which stood its ground and didn't try and devalue the euro.

All of that has changed in the past few months. In June, the ECB finally succumbed to the temptation and started its own mini version of QE. It has the dubious distinction of being one of the few currencies with negative real interest rates for cash deposits. The ECB will actually charge you 0.1 percent interest if you wish to hold on to cash deposits.

France, Germany, Italy and other economies are now recording negative growth for Q2 of the year. But the ECB is wrong if it believes that taking interest rates down to negative territory will help revive economies as people are dissuaded to save and spend money.

Here is what is really happening. As the ECB further slashed its rates and took them negative, the euro started declining. It was trading around 1.39 U.S. dollar to 1 euro when this started.

Now it is trading at 1.33 euro to 1 U.S. dollar. A metric that measures the outflow of euro from EU residents is clearly indicating large outflows of euro as EU residents seek yield on their savings. The euro is flowing out of the EU into bond funds and artificially depressing the yields of these smaller markets as well as depressing yields in the US bond markets as well.

The unintended consequence of an ill-proven policy move has led to the fall of the euro. I believe this move is nowhere near done. I expect a further decline in euro as this exit movement intensifies. As the larger EU economies weaken further, the euro will fall further to a possible 1.25 level in the next several months. Now it should be clear that the euro fall isn't because the U.S. dollar deserves to be strong.

The U.S. dollar is probably the worst of all currencies but will rise against the euro as the euro is currently uglier than the U.S. dollar.

A speculative but lucrative trade can be to short the euro or take a bet that the euro will decline further. This trade can last for some time and a leveraged play could be to trade put options on the euro.

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