Investor Alert
Ivan Martchev

Oct. 25, 2016, 12:05 p.m. EDT

EU's common currency is anything but common

By Ivan Martchev

Shutterstock/Simone Canino
?500 note

It was Voltaire who famously noted that, "Common sense is not so common." His words come to mind when thinking about Europe's "common currency," as the euro is often dubbed. Since stabilizing in the first quarter of 2015, the euro has been in a trading range between $1.05 and $1.15 with a few minor stabs outside that box, in either direction. Two major tests of the bottom of that range ($1.05) "held support" (as traders like to say), and I suspect we are nearing a third such test, which may not hold, in my opinion.

If the British pound is destined to test its all-time low against the dollar ($1.05 in 1985), the euro should be under pressure too as a hard (no-trade) Brexit deal is as bad for Britain as it is for the EU. The euro closed on Friday at $1.0971, marginally undercutting short-term support at $1.10. The Brexit referendum lows were a hair above $1.09 on the EURUSD cross rate, which were taken out on Oct. 21 .

The Brexit effect

The case for a "hard" Brexit is that if Britain is given a sweet trade deal, that will create incentives for other countries to leave the EU. Over the last year, the free flow of refugees that was sponsored by Germany is causing quite the nationalistic uproar throughout the EU now — not only Great Britain — which may cause right-wing movements in France and other countries to follow the Brexit example.

It is unquestionable that Brexit weakened the EU to the core. By definition, it also weakened the common currency, even though the euro has so far declined much less than the British pound. That said, much bigger declines are likely coming in the EURUSD cross rate upon a hard Brexit scenario.

The sales pitch behind the EU's common currency was that it would bring down trade barriers by making trade and capital flows more efficient. If the dollar works so well in a federalist type of country like the U.S., with its multiple states, euro-sponsors thought the euro should also work in the E.U. confederation.

In reality, as the Greek economic fiasco shows and the PIIGS (Portugal, Italy, Ireland, Greece, and Spain) demonstrate, divergent economic models can put serious strain on the confederation's currency. There are already signs that "all PIIGS are not created equal." Specifically, Ireland — and Spain to a lesser degree — are moving in the right direction, while Italy has a very serious banking problem, and Europe as a whole has a very serious deflationary problem. The inability of nonexistent, flexible exchange rates to allow for more flexibility to help many European economies out of trouble is causing serious issues at present.

The introduction of the euro brought down overall interest rates in the euro-zone, which created asset bubbles and accelerated borrowing, which at the moment is resulting in a deflationary bust. The common currency may have been too much of a good thing as the strains are now beginning to appear.

Looking back further

While German 10-year bund yields are at 0.05% (technically positive in name only), European Financial Facility Stability bonds — which can be viewed as the confederate's benchmark — are solidly in negative territory . I think Europe is far from fixing its deflationary problem. It will only get worse under a hard-Brexit scenario. This suggests more unorthodox monetary-policy interventions and a weaker euro ahead.

Looking further back, using the formula of the fixed-exchange rates under which euro-zone currencies were folded into the euro, shows some interesting history. When we look at this "synthetic euro," using its constituent currencies, a rather peculiar correlation reveals itself. Since the U.S. dollar is the reserve currency of the world, the EURUSD and the GBPUSD cross rates seem intertwined . When Soros "broke the Bank of England" in 1992 and the pound fell out of the ERM, that correlation was somewhat interrupted — the same way Brexit is wreaking havoc on the pound now. I think that the liquidity of pound trading is causing the sharper move, but I also think that the euro is ready to follow the pound lower.

It is rather ironic that the seeds of Brexit were sown by the highly successful Soros-led attack against the pound in 1992. A globalist like George Soros was against the Scottish independence referendum and against Brexit, but had Britain stayed in the European Exchange-Rate Mechanism (the predecessor to the euro), I seriously doubt that pragmatic people like the Brits would have voted to leave the EU if they had euro banknotes in their wallets. The fact that they still use rapidly-depreciating British pounds can be traced directly to George Soros and his star manager, Stanley Druckenmiller, and their 1992 pound trades.

It would not be an overstatement to say that the continued existence of the British pound and the independent monetary policy that comes with it became a facilitator of Brexit.

A Fed rate hike would make matters worse

Further complicating matters for the euro and the pound is the talk of Fed rate hikes in the middle of this global deflationary malaise. There is a $9 trillion synthetic short position against the dollar — based on the total amount of borrowing that has been done in dollars by governmental and corporate borrowers outside of the U.S. That number stood at $6 trillion at the end of 2008.

The Fed's near-zero-interest-rate policy for the fed fund rate, as well as QE policies, caused foreign borrowers to take on dollar debts. Many would then sell those dollars and spend them in their local currencies. Now that they have to repay those debts, they have to buy more expensive dollars with their depreciated currencies — due to the more precarious global economic situation causing a dollar surge. The talk of more rate hikes by the Fed is not helping this dynamic. In fact, any rate-hike talks act like kerosene on an already burning fire.

It is peculiar to note that there is some disagreement in the interest-rate market on whether a rate hike is coming in 2016 or not. So far, there are no rate hikes forecast by the December 2016 fed-funds-futures market (black line, here ) and one rate hike forecast by December 2017 fed-funds futures (green line). The way we know this is by subtracting the fed fund futures contract price from 100, yielding a rate where futures traders expect the fed funds to be at the expiration of those contracts in December 2016 (0.4950%) and December 2017 (0.7550%), respectively. Since the present fed funds target rate is 0.50%, there is no increase seen for December 2016 and just 0.25% by December 2017.

As I've said in previous posts, the euro/dollar futures are also heavily correlated to the fed-fund rate. Then there is the divergence between U.S. dollar 3-month LIBOR and the fed funds rate (see chart here ). While highly correlated at times, those rates can diverge. They did diverge massively in the 2008 crisis, less so in 2011, and they are diverging now. (LIBOR stands for London Interbank Offered Rate and is an indication of wholesale funding costs between banks. It tends to rise when banks don't trust their counterparties or when there is a Fed rate hiking cycle expected.) I think the Deutsche Bank (NYS:DB)  situation and feared rate hikes are driving the latest LIBOR divergence. Both situations are supportive of a higher dollar and therefore bearish for the euro, which comprises 57% of the U.S. Dollar Index.

Ivan Martchev is an investment specialist with institutional money manager Navellier and Associates . The opinions expressed are his own. Navellier and Associates holds no positions in any investments mentioned in this article. This is neither a recommendation to buy nor sell the securities mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the above mentioned securities. Investing in non-U.S. securities including ADRs involves significant risks, such as fluctuation of exchange rates, that may have adverse effects on the value of the security. Securities of some foreign companies may be less liquid and prices more volatile. Information regarding securities of non-U.S. issuers may be limited.

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