Playing the ECB News

 | Apr 03, 2014 | 3:00 PM EDT
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This morning, the European Central Bank (ECB) held rates steady at 0.25% and, for now, despite speculation that it would begin a program of asset purchases, or quantitative easing (QE) immediately, its managers declined to do so. ECB President Mario Draghi did, however, in a press conference following the release, make it clear that QE is still on the table should the prospect of deflation continue to rear its ugly head.

European inflation has declined steadily to a level of 0.5% in March, the lowest since the dark days of 2009. The decision not to take bold action, but to talk about doing so, will come as no surprise to those who watch central banks and the ECB in particular. Attempting to influence the markets by talk has long been the ECB's favored tactic and is an inevitable consequence of the unenviable task that the body has. Attempting to set monetary policy for a group of national economies as diverse as Germany and Spain for example discourages precipitate action, and when the eurozone is looked at on average such action looks avoidable.

The fact remains, though, that a deflationary environment could prove disastrous for the still heavily indebted Spain, Italy and Greece and therefore the region as a whole. Inflation devalues currencies and deflation does the opposite. The prospect of servicing and repaying debt in overvalued euros, and, therefore, effectively paying more, is a scary one for the countries already stretched to pay for heavy borrowing in the past. It is likely that even the steady ECB will be forced into action before too long.

I said at the start of this year that Europe could still create problems despite optimism at the end of 2013, and unfortunately, that could well be the case. The euro responded to both unchanged rates and the talk of QE this morning, first jumping when no rate cut was announced, then falling quickly when QE was mentioned.

Trading these immediate moves in the currency markets is really only for the specialists, but my bearish long-term view of euro/dollar (EUR/USD) and euro/yen (EUR/JPY) remains. The currency could be hit with a double whammy in the next few months as deteriorating conditions produce a response that devalues the euro. (QE is effectively printing money, and economics 101 tells us that if the supply of something, i.e. euros, is increased significantly, then that thing's relative value will fall.)

So, if inflation continues to fall and the ECB does respond with asset purchases and euro creation, have you already missed the chance to profit? If not, what is the best way to play it? For the answer to that question we must look no further back than last year and the example of Japan.

It is unlikely that the European response to deflation or the threat of it will be as aggressive as "Abenomics" for the reasons I discussed above, but, while less dramatic, the chances are that the effects will be the same. In the case of Japan last year far and away the most profitable trade was to be short the Japanese currency and long Japanese equities. For the average retail investor, this was most easily achieved by selling the CurrencyShares Japanese Yen Trust (FXY) and buying something like the iShares MSCI Japan Index Fund (EWJ).

Source: VectorVest

As you can see, shorting FXY (left) and using the proceeds to buy EWJ (right) was a great trade for the first half of 2013. Once the trend took hold, it continued for a long time.

As I said, this isn't an identical situation. Not only is it likely that the ECB's policy will be less aggressive than was the Bank of Japan's, but the lingering debt and unemployment problems in Europe could also put the brakes on any jump in equities caused by monetary loosening. With that caveat, though, staying short the CurrencyShares Euro Trust (FXE) and long European stocks via the Vanguard European Stock Index ETF (VGK) looks like a decent bet in the coming months.

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