Forget "Stress" Tests – Three Reasons the Euro's Rise Is Only Temporary

Who would have thought that the euro would have come this far, this fast? After falling to a 4-year low of $1.19 against the US dollar, the European currency has made a sharp recovery – trading today at around $1.30.

But don’t think for a moment that the euro is a safe bet again. The fact is, the euro is floating higher because of three simple factors that could disappear at any time. And its surge has nothing to do with the European Central Bank’s “stress tests” or even Europe’s fundamentals.

For one thing, regional growth isn’t propping up buy-side demand for the single currency. Consumer demand is still lackluster, with the EU’s unemployment rate skyrocketing to a 12-year high of 10.1%. Spain now boasts the region’s highest rate of unemployment, currently at 19.7%.

These high rates will suppress any expectations for positive growth in the near term. And those lowered expectations mean there’s little chance for interest rate increases. Without higher rates, foreign investors will cash out of euros to look for better returns.

Things haven’t changed following the European bank stress tests, either. In fact, the stress tests did nothing but spark controversy and disagreement.

According to the report, only seven out of the 91 banks failed to pass the Committee of European Banking Supervisors (CEBS) test. But the assessments were conducted in a rather soft manner. Instead of making true evaluations of a bank’s sovereign holdings, the CEBS only counted sovereign debt available on the trading desks – instead of both the bank’s holdings as well as the bank’s trading desk holdings. This isolated about 90% of a bank’s exposure to overall sovereign default scenarios – vastly overestimating an evaluated institution’s viability should a default occur.

With the same massive exposure to potentially defaulting nations like Spain and Greece, European banks are still in the same heap of trouble as before.

So what is moving the euro higher? A shift in three simple broader market themes. But they’re all temporary in the wider scheme of things to come.

First and foremost, market sentiment has done an about-face. Since the beginning of the year, traders and investors had been short selling the euro. According to a financial market positioning report released by the US-based Commodity Futures Trading Commission, futures traders had amassed a net short position of over 100,000 contracts worth a notional $18 billion – a record short.

It was only a matter of time until participants reversed their short sells in the market, either to book their profits or to leave an extremely one-sided market. In order to exit a short sell position, traders or investors must buy back the currency, creating demand for it. The mass euro short sell exodus sparked an incredible amount of demand for the currency in recent weeks, helping the euro to appreciate rapidly. Obviously the short covering can’t last forever.

Doomsday fears have also been toned down a bit in the EU region following a handful of uplifting government debt sales. Since the beginning of the year, cash-strapped countries have been given the green light to issue government debt to raise capital. However, with the fear of default reaching a peak, these sales have fallen flat on their face. No individual investor would even glance at a fixed-income bond investment knowing full well that they may lose most of their money.

But one of Spain’s most recent debt sales helped to reverse that sentiment. Instead of poor demand for Spanish government debt, recent auction results were overwhelmingly positive and oversubscribed. Demand was so high that there were three bids for every one bid accepted. The better-than-expected auction results showed resurgence of interest in Europe. China helped in supporting the reversal in sentiment towards European debt. The Asian nation invested 400 million euros in the offering and endorsed further investments in the region.

But the positive sentiment from the auction is not likely to last very long.  Foreign interest in Spanish debt was buoyed only by the relatively higher interest rates that the auctioned bills offered, not solid long-term fundamentals.  In times of crisis or uncertainty, investors can require a higher interest rate on bonds in order to offset a higher level of risk.  The June 15 auction of 12-month bills offered investors a yield of over 2.2%.  That’s almost two full percentage points over comparable US debt.  Should fears of regional default return, foreign investment interests will once again shun European regional debt as it will become too risky to hold.

Foreign expectations of an imminent slowdown in the United States have also helped buoy demand for the euro currency. It’s not news. The United States is dealing with nascent inflation, widespread unemployment and curtailed production.

True, the United States is still in a better position than Europe. But in the grand scheme of things, the euro seems to be the lesser of two evils.  The US dollar has been on a gradual decline for decades as foreign investors consider the United States’ heavy debt burden and penchant for prolonged suppressed periods of growth.  And with United States’ budget deficit estimated to be $1.47 trillion, it’s no wonder foreign money is seeking out the greenback’s counter currency in Europe.

But this could all end if markets see a return to a doomsday scenario for the EU.  Although fundamentals play a major role in currency valuation, if sovereign default speculation returns or the idea of an EU breakup surfaces, investors will surely seek the safety of the US dollar once again – regardless of underlying US economic weakness.

Given the temporary reasons for the euro’s turnarounds, we really can’t expect this rebound to last. The underlying danger that sparked the European financial crisis still remains. And market sentiment could just as easily reverse itself once again. Europe isn’t out of the woods yet, and neither is its currency.

Richard Lee
for The Daily Reckoning