Sword of Damocles Hangs Over the Euro

 | Mar 28, 2017 | 1:00 PM EDT
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We've seen the dollar fall, as per my forecasts, and against the view held by most that rate hikes are bullish for the currency. A dollar is just a Treasury of zero maturity and everyone knows the price of a Treasury goes down when rates go up. Same with the currency. Raise rates, the "price" (exchange rate) goes down. Furthermore, rate hikes are inflationary; they're general price increases and they're also "money printing" as the government is the net payer of interest. Raise the rate and the government spends more, all else equal. I hope this puts it to bed once and for all. 

Of all the currencies out there, I think the euro probably has the most potential. The only thing holding it back at this time is political risk. The French presidential election next month will dictate the fate of the euro, at least in the short term. That's the only thing holding me back from being aggressively long the euro. 

It's not about economic growth. The eurozone has weak growth and some of the member countries are in perpetual recession. So what? You can have a weak economy and still have a very strong currency. Go study Latvia and Estonia's accession to the EU in the mid-2000s. They had an economic depression and their currencies soared. Austerity limits the amount of money the government creates and Europe has been operating under full-blown austerity for the past seven years. 

The eurozone also has negative interest rates thanks to the European Central Bank. Negative rates are bullish for the currency because it's basically a tax. Taxes remove currency and send it to the central bank, out of the banking system, out of circulation and out of the economy. 

The eurozone also runs trade surpluses (although it had a rare, but small, trade deficit in January). Trade surpluses tend to be supportive of a currency as well. So, there's that. A lot of bullish factors underlie the euro, it's just the political risk that hangs over it like the sword of Damocles. 

The two leading candidates in the French elections, Marine Le Pen and Emmanuel Macron, are opposites. Le Pen is an anti-Europe populist. She has openly spoken about leaving the euro and returning France to the franc. On the other hand, Macron is a pro-Europe globalist. He wants to keep the status quo. 

After Trump's victory in November, Le Pen got a big boost. A wave of Trump-style populism was gaining steam. Since then, we have seen some leading contenders for this type of leadership falter. Geert Wilders, for example, in the Netherlands. He lost his bid earlier this month and it was a not-so-minor blow to the populist movement in Europe. Since then, Macron, has pulled ahead in the French polls. I think this has helped the euro sustain its buoyancy lately. 

If Macron wins, I think the euro's path is higher, much higher. There is just so much pent-up bullishness that it's crazy. Speculators have been heavily short the euro for well over a year, so there'd likely be a huge short-covering rally with the specs totally reversing their position at some point and loading the boat long. By then EUR/USD could easily be at 1.30 as opposed to today's 1.08 to 1.09. 

The first round of the French elections will be April 23. There are 11 candidates. If no one wins a plurality, the top two finishers will battle in a deciding second round on May 7. 

According to the polls, if the election were held today, Macron would win, but the polls also said Brexit would be a "no" vote and that Hillary Clinton would beat Trump. 

Take this for what it's worth: Le Pen has been generating huge crowds at rallies, same as Trump. If I were going to make a bet on the election outcome, I'd bet a surprise victory for Le Pen based on those crowds. If that were to happen, then we'd almost certainly see a knee-jerk, Brexit-style selloff in the euro. That could set up a great buying opportunity, but only after we see whether Le Pen will carry through on her pledge to leave the euro. I don't think she will. I don't think anyone will. Even Greece, decimated by the euro and austerity, chose to stay. If Greece didn't leave, nobody will. 

If Le Pen backs off her promise to leave the euro, then the sword of Damocles is gone. It's euro up, up and away; high enough to shut down the eurozone economy and perhaps maybe even convince policymakers that they can no longer afford any more destructive austerity. But that will likely take a long time. By then we could be talking euro 2.0.

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