Euro Morphing Into the Old Yen—the Equation Says So


“In finance you are playing against God’s creatures, whose feelings are ephemeral, at best unstable, and the news on which they are based keeps streaming in.”

                                 Taken from Why Markets Crash, Didier Sornette                                                                 

Commentary & Analysis

Euro Morphing Into the Old Yen—the Equation Says So

What if the euro is morphing into the old Japanese yen?  The Japanese yen which continued to rally for years against other major currencies despite Japan remaining tightly in the bear-hug of deflation for over a decade and nominal rates at zero (ZIRP) for many years?

There is growing concern the Eurozone is falling into a Japanese-style deflationary trap as the headline inflation rate across the zone continues to decline.  Many expect the European Central Bank will be forced to cut interest rates. 

I’m not sure declining headline inflation should be a big surprise given the unleashed domestic deflationary powers of austerity in an effort to save the single currency regime.  But one interesting aspect of this is the surprising strength of the euro even though the Eurozone is losing the yield and growth game to the United States.

I want to share with you an equation I took from George Soros’s book, The Alchemy of Finance, when I read it back in 1987; which is doing a pretty job of justifying the path of the euro. 

T + ↑ N + ↑ S →   ↑e

↑ T – Trade Surplus

↑ N – Non-speculative Capital

↑ S – Speculative Capital

↑ e – Exchange Rate

1.     The Eurozone is still sporting a nice trade surplus.

2.     Non-speculative capital flow seems to be increasing as banks in Europe delever outside of Europe in order to bolster domestic capital.

3.     Speculative capital flow into periphery bonds, turnaround assets, and buying bad debt (vulture funds) has been brisk, as international fund managers find opportunity across Europe. 

4.     Therefore, the exchange rate is rising despite what from the outside appears to a relatively bad economy.

Is it that easy?  No.    

Markets are full of rational and irrational beings; and those beings can quickly move through various stages of rationality when it comes to money decisions.  So, if we consider a situation whereby irrational beings are participating and impacting on the outcome they are also attempting to forecast (Soros’ Theory of Reflexivity), you can see the difficulty in using equations to determine outcomes.  It’s highly unlikely any Holy Grail-type equation will emerge until Chaos theory and computing power are much further advanced. (That’s a story for another day.)

Despite their limitation in predictive power, I do think equations play an important role as a framework for scenario analysis (I create my own homegrown equations to try to better understand money flow; all are flawed to one degree or another).  In the case of the equation I shared above, even if it breaks down as a rationale for the euro, i.e. the euro tanks, I do think it is helpful for thinking about how much flow impacts a currency and can run contradictory to the usual consensus regarding headline GDP or levels of interest rates. 

In retrospect, Soros’ equation was an excellent framework for understanding why the Japanese yen remained strong despite Japan’s dismal economic woes.  At the moment, it seems to be doing a pretty good job of defining rationales for euro strength.  But Mr. Draghi is back behind the microphone on Thursday; so stay tuned.

Interested in the Black Swan Forex Service ?  If you wish to sample the service, just send us as note.


Jack Crooks

Black Swan Capital

Phone: 772-349-6883



Get a load of this tidbit out of the IMF ...


It seems like this can shake out one of two ways:

  1. A new effort to air the dirty laundry. As long as global policymakers are being seemingly transparent, then the consensus will believe things will remain relatively under control thanks to these devoted policymakers.
  2. A genuine attempt to pressure the euro lower. The common currency remains a key feature of the Eurozone growth struggles. The periphery certainly won’t welcome a further rise in the euro should it break above nearby levels. As long as the IMF volunteers further action from the ECB, the outlook for the yield dynamic appears to favor the US dollar over the euro.

The former might mean the euro continues to climb higher. The latter, should sentiment sufficiently turn, would mean the euro rolls over and begins a push lower.



Fed up. In Italy ...

The Federal Reserve is up to bat again today. And it seems the bets on tapering are rising with each passing moment.

Let's just say I'd be surprised if they announce tapering today. I have several reasons why, but let's just say the state of things in Italy is on the Fed's radar screen.

As it pertains to tapering expecatations, we've provided thorough details and analysis in recent issues of Global Investor (for paid members only.) But let me summarize a few pieces with broad strokes:



  • Inflation is not pressuring the Fed to change policy
  • Potential adverse global market reaction to a perceived change in rates is pressuring the Fed to sit tight
  • Further, tapering could counteract the influence of Japan's Abenomics which accomodates a renewed yen-carry trade
  • The adoption of the Volcker Rule creates new uncertainty in the US financial system
  • The fragility of the European financial system has become heavily dependent on Fed activity



I think most of those items are self-explanatory. But let me update you on the latter ...

If you don't regularly read Ambrose Evans Pritchard in The Telegraph, you should. He's very thoughtful and very critical. And his focus tends to be on the Eurozone. (Note: As good as Pritchard is, try not to let his analysis dictate your trade timing. It doesn't work even when it sometimes feels like it must!)

Anyway, he had a piece published yesterday: Italy’s president fears violent insurrection in 2014 but offers no remedy

And here is the crux of his piece, questioning why Italy is in the crummy predicament to which its President admits:

Now why might that be? Might it not have something to do with the central overriding fact that Italy has a currency overvalued by 20pc or more within EMU: that it is trapped in a 1930s fixed-exchange system run a 1930s central bank that is standing idly by (for political reasons) as M3 growth stalls, credit contracts, and deflation looms?

And later he goes on to say:

To those who keep insisting that Italy should tighten its belt and claw back competitiveness by cutting wages, I would contend that this is mathematically impossible in a climate of EMU-wide deflation or near deflation.

The reason should be obvious to everybody by now. You cannot allow the nominal debt stock to rise on a shrinking nominal base. Such a policy causes the debt trajectory to spiral upwards. Italy’s debt has already jumped from 119pc to 133pc of GDP in the last three years in large part because of the fiscal austerity policies.

Yeah, it should be obvious. But that doesn't mean it won't continue to be ignored ... by Germany.

One may be inclined to think the Eurozone is on the mend just like the US, just behind the curve a little bit. We hear all kinds of things about how valuations in Europe are attractive. But I'd argue that assumes a lot for the Eurozone's growth future. I think "attractive" valuations are also relative, i.e. how European markets stack up to US markets. (Doug Kass recently stated he thinks US markets are 8 to 10 percent OVERvalued.)

The biggest threat to Europe-on-the-mend is political and social discontent.

Germany this week launches its grand coalition, a deal between parties on which direction to take German policy. And it's not been met with kind words. From The Telegraph:

“The agreement does not contain anything that would solve the European debt crisis, re-ignite growth in the euro periphery, or dampen the disastrous impact of austerity,” said Sebastian Dullien from the European Council on Foreign Relations in Berlin.

Prof Dullien said it had blocked a viable EU banking union and left in place the “toxic vicious cycle” between weak banks and weak sovereign states, each at risk of pulling the other down.

Geez. What more is there to say?

Alright, since you praise my every utterance, I'll explain what this means in my own words:

Germany will not be making any changes that meaningfully impact the Eurozone dilemma in a positive way.

And guess who isn't going to like that? Perhaps the rest of the eurozone, maybe? From an older Pritchard article:

... the new plan of Romano Prodi, Italy’s former premier and “Mr Euro”. He is now calling for Italy, Spain, and France to band together rather than deluding themselves that they can go it alone, and to “bang their fists on the table”.

Nobel economist Joe Stiglitz echoes the theme at Project Syndicate. “If Germany and others are not willing to do what it takes – if there is not enough solidarity to make the politics work – then the euro may have to be abandoned for the sake of salvaging the European project,” he said.

Frankly, nothing is going to get done in Europe anytime soon. 

The best they can hope for is a perpetually effective perceptions management campaign led by the European Central Bank's own Mario Draghi. His strategy (similar to most policymakers of the last few years) is to air some of the eurozone's dirty laundry (namely, vague concerns for Eurozone growth) so markets feel like they're in the know.

But regardless of the "disclosures", if the markets get blind-sided by what's really preventing progress in the eurozone economy, they'll get spooked quickly.

And one more blurb from a different Prtichard piece:

“Every 10pc rise in the euro costs France 150,000 jobs,"said Montebourg. "Britain, the US, Japan, all have a strategy of monetary stimulus, but in the EU we have nothing but hard money and hard budgets. The currency doesn’t belong to bankers, and it doesn’t belong to Germany, it belongs to all members of the eurozone, and we have something to say about this,”

Is that a threat to invoke Article 219 of the Lisbon Treaty giving EMU ministers the final say over the exchange rate, a power that lets them dictate monetary policy by the back-door, provided the Commission plays ball?

A Deutsche Bank study said the euro “pain threshold” for Germany is $1.79 to the dollar. It is $1.24 for France, and $1.17 for Italy, a staggering difference. The euro ended last week at $1.35. This means Germany is sitting pretty, and it is Berlin that dominates the policy machinery.

Yes, indeed -- the US has a strategy of monetary stimulus. And the arbiter of that stimulus is very mindful of the situation in Europe and its potential contagion effects if Fed tapering sparks a rethink in markets.

Tapering rhetoric shocked markets when first broached in May. At most the Fed will test out the rhetoric again today so that they may see how markets react. But ultimately they are stuck because they've generated a global "wealth effect" dependent upon monetary stimulus.

-JR Crooks


Eurozone economy will "turn the corner" ... to a new LTRO?

And the headlines read:

Sharp euro zone inflation drop, record joblessness add to ECB conundrum (Reuters)

EU sees 'hope' but also lower growth (BBC)

Euro zone economy turns corner, but growth, inflation subdued: EU executive (Reuters)

Well, the downward revision of growth from 1.2% to 1.1% is certainly not jaw-dropping. But is it enough to spark a subtle shift in sentiment that generates a more fragile consensus on the eurozone?


The joblessness is no surprise. As it has been in the US, unemployment will be a critical impediment to the eurozone's economic recovery. Spanish utility Gas Natural Fenosa has particularly acknowledged the depressed demand in Spain and the nearby areas. It's due very much to the severe unemployment situation. Gas Natural seeks to make its progress and profit in Latin America in the coming years because the outlook for economic growth in the eurozone remains grim.

But perhaps the most important piece of the headlines to be pulled out is the inflation data. We know what subdued inflation means in this era of monetary accommodation: more accommodation.

Does that mean another LTRO (Long-Term Refinancing Operation) is right around the corner, the same corner around which the eurozone economy will supposedly turn?

Doubtful, at this stage. But don't abandon the idea completely. If things get nasty, the European Central Bank will need to do something to help re-recapitalize a financial system built on crummy collateral. 

Instead, what's more likely in the interim is the strategy du jour for central banks: talk the market to sleep. 

The ECB's rhetoric, perhaps when they meet later this week, in light of subdued inflation, will signal:

  1. Economic activity shows stabilization but still has room for improvement
  2. The central bank has room to provide additional support measures IF needed without fear of generating inflation or asset bubbles

In other words: don't worry about the economy. But if you do, remember we're there to backstop it ... so don't worry about the economy.

Ok. Got it. More accommodation. Woo hoo. So what?

So, barring any real shocks to the financial system, real or perceived, we're left to juxtapose expectations for the European Central Bank and the Federal Reserve.

In the weeks following the agreement reached on the US debt ceiling, market expectations shifted mightily into believing Federal Reserve tapering was to be long-delayed. Decent US economic data is surely to erode that enthusiasm and expectations will then shift back to believing tapering is on its way in.

Assuming I'm right about the inevitable shift in Fed expectations, and the ECB's further-accommodation-if-needed rhetoric, the resulting change in yield differential will be US dollar supportive.

And that seems appropriately timed, since in just the last few weeks predictions for the US dollar's demise have ramped up noticeably. And this story about South Africa diversifying their currency reserves is sure to validate the bears' collective growl.

The euro may recoup some of its recent sharp losses in the coming days. But it could have very likely already made it through a turning point of its own, one that sends the value of the euro much lower in coming months.

-JR Crooks

P.S. We mentioned the open EUR/USD trade last week that was showing open gains of about $1,500. Well, that trade is still open in Jack's Black Swan Forex trading service -- and it's now showing $2,810 of open gains per one standard-sized lot. And Jack's locked in, gauranteed, $2,540 of it.

Click here to see how the rest of Jack's trading advice has panned out this year. I imagine you'll be impressed.


IRELAND: The lifeblood of the eurozone for the next few days

The 20-period Bollinger Bands on a chart of EIRL (iShares MSCI Ireland Capped ETF) narrowed dramatically. And now they are expanding. Along those lines, an indicator I like to watch suggests EIRL is in the second day of a five-day move to the upside.

I suspect such a move could coincide with the last hurrah for Eurozone markets in the intermediate-term. After all, measured by EIRL, Ireland has been going bonkers since the middle of summer 2012. 

Spain, measured by EWP (iShares MSCI Spain Index Fund) has been going wild too -- it's run in just the last month and a half totals better than 24%!

Germany (EWG) and Italy (EWI) are following suit. 

But it seems as though this "buy the Eurozone because the worst is behind them" theme is about to run its course. And any further advances will need to be accompanied by legitimate improvements in the data or at least sentiment.

This article from the Telegraph explains how the apparent improvement in the outlook for Spain is not well founded: An apology of sorts -- Spain not bust after all

And this article from the Telegraph explains the chatter surrounding Ireland's likely exit from bailout territory. But it's got to be nothing but another PR gimmick to buffer the ongoing political turmoil with "good news."

After all, France's established political parties are undergoing a real test from a far-Right anti-euro party whose leader is running on the campaign promise that the euro must be dissolved orderly or France will exit uncooperatively.

And Greece is battling through similar polarization. But the difference is that Greece is still in bailout territory. And should things not go smoothly, more bail-outs would be likely. And that doesn't even factor in the potential bail-ins that would generate a sort of Cyprus-like deja vu.

As that last article implied, I'd be careful piling in with the hedge funds who are ready to bet the eurozone is out of the woods.

-JR Crooks


Setting up for a US growth disappointment

It seems the US trade deficit data released yesterday went largely unnoticed. And that's usually how it goes each month, probably because there tends not to be much, if any, knee-jerk market reaction to that report.

But considering how most markets have been moving this week (up), it got me thinking about how the trade numbers might influence markets over the next few weeks ...

To recap: the US trade deficit widened sharply in August. That followed the previous month's narrowing to a level not seen since October 2009.

I was particularly wondering how this might impact the US dollar. There is not a tight correlation between the US trade balance and the US dollar, especially over the shorter-term. But the widening trade deficit is a nod to the typical dynamic -- trade imbalances -- that's characterized global growth over the last decade.

Manufacturing PMIs in US, Europe and China are all higher in the most recent month, poking above the 50-level that delineates expansion and contraction.

Despite the recent scare over emerging markets, many are quick to notice a general stabilization in global growth expectations.The US economy has been the least of the concern for investors. But if the world is seen to be stepping back into what's been a typical growth pattern, then maybe Asia (namely China) gets cut some slack. 

In an environment where things seem to be "back to normal," then maybe we see capital exit the US in search of return. Maybe the US dollar loses any safe-haven appeal and is potentially looked at as a funding currency. And maybe most markets around the world feel a reprieve from recent selling pressure.

Obviously this is all speculation on my part. And it's all speculation that I imagine would run its course in a relatively short period of time, say three to six weeks.

So I may be stretching it to think the trade deficit could have such an influence on markets in that amount of time.

But one reason (among many) I tend to think such a "back to normal" growth mentality won't last too long: the recent US GDP beat was driven largely by a surge in exports.

As mentioned, the latest trade deficit number showed the surge in US exports reversed last month. In other words: come the end of September or early October, everyone may be rethinking their expectations for the US economy. And if they start rethinking the US, chances are they'll start rethinking global growth as well.

This chart is from Part 5 of a five-part series The Wall Street Journal put together on "China's Rising Risks." Click the image to access the article.

September is well known for being the worst month for US equity market performance. That may be reason enough to expect the opposite in the early going. After all, the catalysts for market weakness -- mainly concern for emerging markets and rising interest rates -- are probably overdone in the near-term.

I expect a reprieve from general selling pressure in global equity markets and other risk assets over the next few weeks. In that environment, the US dollar probably will be pressured lower. Once the US dollar is again looked at as a dog, it should be about time for it to head higher as many have been quick to forecast in recent months.

-JR Crooks



Can the Fed rest? An experiment in social resilience ...

Most of the headlines this morning blame yesterday’s market fallout on expectations of Fed tapering. Many are citing the improvement in US economic data as evidence the Fed doesn’t need to keep its bond and MBS purchases going.

Critics have rightly lumped blame on the Fed’s QE policies for failing to directly and efficiently energize the real economy. But it’s hard to argue against the influence it’s had on investor sentiment over time.

That slow improvement in sentiment seems to have finally restored confidence enough to generate legitimate new loan activity. Here is a chart of US commercial & industrial loans: 


Since 2011 it’s been a steady climb and this metric is approaching the 2009 peak level. It took two years and two rounds of QE, but demand for C&I loans returned.

That this data is on the verge of retaking pre-crisis levels can be cited as additional evidence the US economy can stand on its own without the Fed’s omnipresence. Of course, a Fed exit could generate nervousness and create a relapse that sees the credit markets seize up again. After all, willingness to lend and borrowing was at the heart of the financial crisis (it was not so much a matter of banks’ ability, or inability, to lend.)

So, what’s my point?

Well, I think the Fed is still worried about conditions outside the US, namely Eurozone banks, as it considers its exit strategy.

So I went to the European Central Bank’s website this morning to find their equivalent of commercial & industrial loan activity. Here it is, monetary and financial loans to non-financial corporations: 


Not only is this metric not approaching its pre-crisis peak, it’s actually at its lowest level since the crisis hit in 2008/09. And it goes to the point that Europe is not out of the woods.

Despite the relative improvement in Eurozone economic sentiment in recent weeks, the potential for its economy and debt levels to improve remain poor. Jack sent me this chart from The Wall Street Journal earlier today:


Needless to say, Europe’s financial system remains vulnerable. Quality collateral is an issue as its banks seek to bolster their balance sheets in an environment where demand for loans that drive economic growth is wallowing.

There is a scarcity of quality collateral that necessitates new collateral creation of less quality ... as well as a system willing to accept it. The problem here resides in the resulting increased interconnectedness between collateral and financial markets. As the banking system becomes more tightly coupled with the markets and securitization through this new collateral, the impact from a market shock is intensified and and spurs a negative feedback loop where quality collateral becomes more scarce.

Considering how much money the Federal Reserve is providing to foreign banks (more than $1 trillion and more than to US banks, YTD as of July 31) you have to think it harbors significant concern for European banks in particular. The Fed realizes its departure from QE could very easily and very likely generate a sharp drop in the market, even if the decline is relatively short-lived and the US economy is truly on solid footing.

But even those who think Europe’s economic decline is moderating won’t dare suggest Europe is on solid footing. So what type of contagion will spread from Europe if a Fed-induced market shock sends their financial system, the largest in the world, reeling?

Certainly not any type the Fed welcomes (unless of course the Fed truly wants to end the global dependency and untintended consequences of its monetary policy -- ha!)

I suppose the Fed is between a rock and a hard place -- succumb to the pressures from the BIS who cited growing risked from increased QE ... or risk contagion from a European banking system that's left to fend for itself (so to speak)?

Considering their "do something, do anything, to mend the global economy" track record, I suspect they'll err on the side of keeping QE in play so as to manage the markets and bide more time for Europe.

It's be interesting to see how this experiment works out ...


-JR Crooks


I solemnly declare the Eurozone healed. (Just kidding!)

What is interesting is that during Japan’s lost decade [from 1991-2001] it outperformed the Eurozone in all categories: growth was faster, debt growth was slower, manufacturing productivity was higher, and labor costs grew more slowly.

Obviously there are several takeaways here, and we haven’t even broached the disastrous social impact of towering unemployment rates [specific country brain drain, birth rates, fall in scientific research, family strife, suicides, etc.]:

  1. If growth doesn’t resume soon, debt/gdp ratios across the Eurozone will mirror Japan’s; but in many ways because of such poor relative productivity and size of the Eurozone banking system the rise in debt will likely be that much more dangerous. 
  2. As a hub for future industry in a globalized world where multi-nationals have so many choices, it looks bleak for countries inside the euro straight jacket.  In short, foreign direct investment will go elsewhere. 
  3. Instead of bringing cultures together, the single currency is helping bring old animosities to the surface, which are numerous thanks to two recent civil wars (WWI and WWII).  

It seems unless something very big happens fairly soon, politicos across the Eurozone will be responsible for marginalizing the future of their people simply because they have invested so much political capital in this bold, but seemingly failed, experiment called the single currency despite passing by all the signs that read, “Turn back now!”

So, what is the endgame here? 

Click here to continue reading ...


Yield Differential Still Seems in Charge of Euro versus US dollar

To show a market correlation is to show a market correlation.  That is about it.  The reason I say that is because we can never really be sure which of the pieces of price data in the correlation is leading and which is following.  And to go further, even if we did know which was leading we then run into the problem of then "forecasting" where the lead piece of price data is going in order to help "forecast" where the follower is going.  Thus, I think correlation analysis is useful, but it must be handled with caution.

In that vein, you have probably heard plenty of people trying to forecast currency prices using a forecast of interest rates. 

Read on ...

Currency Currents 25 July 2013