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  #2097 (permalink)

West Java
Posts: 145 since Apr 2014
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 During that period USDJPY actually fell from around 112 to 105. One of the bullish arguments made for the
EUR is that as with Japan the combination of the deflationary dynamic and current account surpluses ended
up giving us a stronger JPY. The issues we have with this comparison are numerous
– Japan has a single bond market with no question of default being entertained
– Japan is a single economy
– Japan has a single political structure
– In times of crisis Japan pulls together like “Japan Inc.” while Europe (A loose confederation of independent
states) tends to fragment
 The bottom line here is that Europe needs a weaker currency (More on this below)
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 Next big resistance above 65 basis points is around 180+ basis points
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 Initial resistance is at close to 230 basis points (1999 peak)

In the fixed income section we look closely at the 2 and 5 year US yield charts which still suggest that we
may be “on the cusp” of a move higher very soon
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 It is very clear looking at the chart above what is “different this time”
 When the ECB misguidedly raised rates in 2008 because of inflation, Oil prices had been surging (virtually
tripling in price over 18 months from Jan 2007 to July 2008). However that surge in oil prices had nothing to do
with the dynamics of the European economy and was therefore like a tax. You do not tighten monetary policy
on the back of a tighter “fiscal” picture , quite the contrary (unless you are the ECB)
 Unfortunately exactly the same mistake was made in 2011 after the Oil price surged from the 2009 lows (more
than tripled in price over this period)
 As we can also see above in the backdrop of the financial/economic/housing crises of 2008-2009 we saw the
oil price collapse and along with it inflation. This led to the ECB easing from 4.25% in Sept 2008 to 1% in April
 So what is different this time?
 Inflation has collapsed (from 3% in Nov 2011 to 0.3% in August 2014) and monetary conditions have tightened
(See EC monetary conditions index chart below) while Oil has gone effectively nowhere. In effect, to date,
higher real rates and the up move in the EUR from 2012-2014 have effectively been the main culprits in
tightening conditions with a feedback loop to a structural fall in inflation.
 So here’s the potential irony. The oil price has fallen quite sharply in the last 3 months and looks in danger of
breaking pivotal supports (See WTI chart below). Even on the chart above (Oil in EUR terms) we can see it is
in danger of breaking down out of the consolidation in place since early 2011. If this happens, with the
Eurozone inflation rate now at 0.3%, despite the fact that this would be good disinflation (Lower Oil prices,
money in people pockets etc etc) it is likely to increase the concerns of deflation in European circles and
induce an even greater propensity to introduce further “unorthodox” monetary stimulus i.e. The calls for full
blown QE will likely grow.
 Even if that is the case, that is ok. Why. The Eurozone needs further stimulus and it is not clear to what extent
further monetary policy adjustment can provide this. What can provide this is a lower EUR and hopefully at the
same time a lower oil price.
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 WTI has formed a clear head and shoulders top with the break below $96 on a weekly closing basis. In
addition we also saw a weekly close below the 200 week moving average the same week.
 That head and shoulders formation suggests a fall in excess of 21% following that break which targets around
$76. In addition good 2011/2012 support is met in the $75-77 area.
 While forming the head and shoulders the Jan-June bounce from $91,24-$107.73 was a near perfect 76.4%
pullback of the August 2013-jan 2014 fall.
 This suggests that a weekly close below the pivot off which this 76.4% pullback was created ($91.24) would
open up the way for an acceleration of downside losses towards this $75-77 area possibly by late 2014/early
 That would equate to about a 17% fall from present levels. While such a move would be very stimulative to the
US, even if EURUSD were to fall to 1.22 in that period (just over 5% below present levels) it would also be
very stimulative for Europe.
 However, as mentioned above, even though that would be “good disinflation” it would likely put the ECB even
more on edge with regard to its inflation target.

Why the ECB was right to continue to ease -but needs to do more: Monetary conditions index/ real interest rate/
real effective exchange rate. Europe NEEDS a lower EUR as part of the solution. A lower EUR is no longer part of
the problem
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 What this chart shows is European commission monetary conditions index and its 2 components
– The REER- Effective real exchange rate
– RIR- Real interest rate
 A move higher in the MCI means looser conditions and vice versa.
 This index has effectively tightened in a straight line from August 2012 to March 2014. Why?
 Firstly during that period we went from an inflation rate of 2.6% and an ECB rate of 0.75% (Negative real yields
of 1.85%) to an inflation rate of 0.5% and an ECB rate of 0.25% (Negative real yields of 25 basis points…or a
real tightening in monetary policy of 160 basis points.)
 During the same period EURUSD went from 1.2134 to 1.3967 (+15%) while the Deutsche bank EUR trade
weighted index also rose by 15%. (This index is 34% USD;15% JPY;11% CHF 31% GBP and 9%SEK)
(Source Bloomberg)
 The European commission calculates the there is a 6:1 ratio between the RIR and REER in terms of how it
affects monetary conditions. i.e. A 1% move in the REER is equivalent to a 16.66 basis point move in the RIR.
Thereby a 15% move up in the value of the EUR is equivalent to almost 240 basis points of monetary
 So over this period we have seen effectively the equivalent of about 400 basis points in tightening (160 from
RIR and 240 from the exchange rate.) Since then the exchange rate has dropped about 5% (about 83 basis
points of easing while inflation and ECB rates have each dropped .2% (No real change in RIR)
 From here there is little scope for the RIR to improve unless inflation moves up sharply. There is also little
scope for fiscal stimulus. This leaves the exchange rate as the primary vehicle for stimulus. If we were to get
the 32% fall in EURO as we did in 1998-2000 that would equate to over 500 basis points of stimulus.
 It is very hard to see where else this stimulus can come from which is why it is now obvious that the EUR
needs to go lower and that the ECB recognizes this.

So from our perspective:
 The historical picture in favor of the USD lines up
 The traditional technical picture lines up
 The interest rate differentials line up
 The economic divergence lines up
 The inflation divergence lines up
 The move in opposing directions of monetary policy lines up
 One central bank (Fed) does not care if the USD strengthens and the other (ECB) is quite obviously
supportive of a weaker EUR.
 In fact we would likely argue that if anything the relative European-US dynamic looks worse for Europe
this time around than in that prior 1989-1998 cycle.
Bottom line, we have every building block that we can think of that supports our view that we can see
EURUSD move towards and possibly below parity by 2016.


Last edited by Thxo; September 12th, 2014 at 03:27 PM.
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