To contact FX CONCEPTS New York: 1 (212) 554-6830; London: +44 20 7213 9600; Singapore: (65) 67352898; research@fx-concepts.com

Trees Don’t Grow to Heaven
By John R Taylor, Jr.
Chief Investment Officer
At some point in every mass social phenomenon, the participants involved reach the
point where the trend overwhelms everything else and rational judgment loses out to
emotion. The most famous example is the Dutch tulip bulb craze, but the tech bubble in
late ’99 and early 2000 would seem as good an example. These emotional over-shoots
happen all the time on a smaller scale, but the bigger the scale the larger the irrational
pricing beyond the fundamental realities. This desire to follow the crowd is what makes
trend-following successful – when it is impossible to understand the basis for the price of
an instrument, the best thing to do is follow others – whoever they are and whatever
their reason – who have already committed to the price. We refer to this conceptually as
model uncertainty: when the historic references no longer apply, the only benchmark you
can find to protect your investment – and your job – is to do what the others are doing.

Right now the crowd is borrowing the US dollar or selling it outright. Among the vehicles
that have looked especially attractive for expressing this view are peripheral debt
instruments within the euro-block. If the euro is to continue in its present form through
the investment horizon, then buying Spanish or Irish government bonds would seem a
very good bet – they pay more than other euro investments and they are ‘euro-
denominated’. Ever since the last days of November 2011, a very dark time for the
European dream, when the European Union, the ECB and the several dominant
countries showed their willingness and their ability to unset powerful political figures who
could upset their program, the European sovereign debt market has rallied relative to the
dollar bond market and those of the rest of the world. Since the removal of Berlusconi,
no other prominent leader has voiced any disagreement with the German-led program.
In July 2012, when Mario Draghi sharpened the issue by focusing on the immediate
problem of the euro and stating forcefully that the ECB had the tools and would act
strongly to do whatever it took to save the euro, the game changed completely. Not only
would recalcitrant leaders be forced to acquiesce or else, but there would be no doubt of
the euro’s survival. When it became possible to buy euro securities with both a high
yield and a currency that was controlled by Germans or German-like institutions, they
sold like hot cakes. Actually, it took quite a few months and a track record of great
performance before the trend became so obvious that everyone wanted to join it. The
pendulum has swung so far that governments within the Eurozone with debt loads of
over 100%, very high tax loads and government participation in the economy, no
economic growth, and no inflation can borrow at rates below countries like Canada,
Australia, and New Zealand whose economies and demographies are dramatically
superior to even the best Eurozone country. Within Europe the spread between
Germany and Spain is still dropping, but it is the market strength of these weak
economies versus the US and other outside markets that shock and drive the global
market to its current extremes. The French 5-year rate is below the US by 84 basis
points, while Spanish and Italian rates are roughly equal to those in the US. Because
there is a clear difference in the credit quality between Germany and the others, the
German market is being driven to irrationally low levels by this global desire to
participate in the peripheral credit market rally. In turn, richly priced peripheral bonds
impact bond prices everywhere pushing the global bond market higher. This tree is
already pretty close to heaven and when Draghi cuts rates on June 5, it will touch it. With
deposit rates below zero, German rates can’t fall further and the peripheral rally will fail.
Spreads will soon widen and the euro will begin to fall.
To contact FX CONCEPTS New York: 1 (212) 554-6830; London: +44 20 7213 9600; Singapore: (65) 67352898; research@fx-concepts.com

CURRENCY – Europe Long-Term View

By John R. Taylor, Jr.

Recently we have noted that the 10-year
Bonds of some highly rated countries
have been yielding significantly more
than those of Italy and Spain. We have
nothing against those two countries, in
fact we find them great places full of
wonderful people, but to us their
economies are not doing well and they
are facing significant financial risks in the
years ahead. Why would someone
buy Italian 10-year paper when
Australian 10-year paper has been
yielding 70 to 90 basis points more?

At some point this wonderful European bond market rally is going to come to an end,
and our cycles say it should have happened already. The chart to the right shows the
spread between French 5-year sovereign paper and US 5-year Notes since the first half
of 2011. The French premium has been as high as 1.88% just at the time the European
authorities forced Berlusconi to step down as Prime Minister. To the current low spread,
which has US yields 84 basis points above the French ones. This trend should be over.
Our cycles argue the low should have been in the second week of March and we
see a re-test of our projected low in the first week of July. It is possible this will be
the final low for this re-rating of US-French risk. We have chosen France as the market
to compare with the US, as it is obvious to almost everyone that the French economy is
doing poorly even though it is in no immediate financial predicament. Looking at this
historically, French yields have almost never been this low relative to the US. Only
during the 2005-2006 timeframe, when the euro project seemed to be running so well
and the world was in the middle of the Great Moderation and back in the period between
1997 and 2000 when everyone and her brother were euphoric about the coming of the
euro. One would think 15 years later we would be a bit wiser, but we are not.

The currency chart shows the US dollar relative to the euro – that is inverted from the
normal picture. The dollar rallied from the end of August 2011 to the following July when
Draghi gave his we’ll-do-everything-to-save-the-euro speech. Since then the USD has
been declining and the EUR/USD has been rallying. There was an intermediate dollar
high last July and the downtrend from that high has just been broken, which is apparent
on the chart. That level for the EUR/USD is the 1.3790 level and we are expecting a
drop to the 1.3580 area at the end of next week or in the week of May 26. We are
also expecting another attempt to the downside for the USD into the end of June or the
start of July. That could possibly see a new USD low, coinciding with a higher level of
euphoria about euro assets. Our analysis argues very strongly that French and
peripheral hopes will be dashed and the EUR/USD will decline back through the 1.33 to
1.34 level and eventually into the 1.20s, probably by year-end.

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