In-depth analysis on Credit Writedowns Pro.

Has the Euro Broken Out?

By Marc Chandler

The euro has risen to about $1.3270 today, the highest level since December 12th. Some observers are attributing the euro strength to creeping optimism that a Greek deal is nearly at hand. Color me skeptical.

Fed Chairman Bernanke’s comments, the first since the employment report, remains decidedly dovish and this seems to be a better explanation of the dollar’s weakness. He argued that the 8.3% unemployment rate understates the weakness in the labor market.

That seems to be incontrovertible. Economists appear to be in general agreement. However, the fact of the matter is that a number of indicators do point to some improvement in the labor market, and Bernanke did recognize this too, even if his main thrust was dovish.

The fact that 42.9% of the unemployed have been jobless at least six months suggests an increasingly structural problem rather than simply cyclical. This is an important distinction as monetary policy may be capable of addressing the latter but not the former.

In any event, the key take away is that some observers pushed out expectations for QE3 after the jobs report. Remember the Fed forecasts unemployment to average 8.2%-8.5% this year. It was 8.3% in January, after falling for five consecutive months. And Bernanke seemed to bring it back.

There have been a number of so-called deadlines that have proven otherwise in this marathon negotiations with Greece for a second aid package. Two developments today seem striking, even though an agreement remains elusive.

First is comments by Merkel. Contrary to polls that suggest a majority of Germans would be happy to see Greece leave the union, the Chancellor is less sanguine. She says not only that she does not expect Greece to leave EMU, but that its exit would pose "incalculable risks". This is the Lehman-like event that many policy makers fear.

Some noted economists have called for Greece to leave the EMU to devalue. They suggest that this will help stabilize the euro zone. European officials disagree and for good reason. The exodus of Greece could very well intensify the pressure on Portugal. We have been down this road before and key European officials do not want to take this risk again, regardless of the advice from academic economists.

One must not under-estimate the political prowess of Merkel. She might not get an EU Commissioner to oversee Greece’s fiscal sovereignty, but she may very well secure another objective expressed in the recent proposal. Germany proposed that Greece agree that the first call on state revenues was servicing its debt.

European officials reportedly support the new German-French call for the establishment of an escrow-like account into which parts of the second aid program would be deposited. Ostensibly this account would be specifically earmarked for servicing Greece’s debt and would, it is argued, reassure Greece’s creditors.

Aid needed to run the Greek government could separately be withheld if the Troika concludes that Greece is not implementing the reform agenda in a satisfactorily, without destabilizing the markets. Since Greece got its first aid package in May 2010, nearly ever periodic check by the Troika has injected extra uncertainty in the market. Greece has received ever tranche to date, but only after arduous negotiations and brinkmanship.

It is important for the stabilization of the capital markets that the payments are decoupled from the threat of default. The escrow account scheme is one way, as the Financial Times quotes a senior French official as saying of "removing the Damocles sword of default" while still pressing Greece to implement critical reforms.

The second eye-catching development comes from the head of the small nationalist party that supports the Greek government. He opined that the Troika demands may violate EU law. That such a claim comes at this late date borders on absurdity.

It matters not an a single iota if the claim is factually true in some legalistic sense. This path of resistance is a dead end. In many ways, the Troika is now the law. Indeed is not that the golden rule–he with the gold makes the rules ?

The tactics of brinkmanship requires pushing as hard as possible for as long as possible before capitulating. The "as hard as possible" means making incessant demands and if the adversary agrees, demand more to squeeze out as much as possible. The "as long as possible" refers respecting objective deadlines not self-imposed deadlines.

The real deadline that matters is the March 20th bond maturity for which Greece needs about 14.5 bln euros. However, because of the complexity of the legal maneuvering necessary for the bond swap (of the PSI) as well as other machinations, an agreement needs to be struck a few weeks before that. Some experts has suggested 3-4 weeks is necessary. That means that the wrangling can continue for a bit longer.

What does this mean for the euro? Given market positioning and the anticipated long-term repo operation at the end of the month, it is tempting to see this move above $1.3250 as a breakout. The 3-year LTROs will likely be sufficient to ease the banks’ roll over risks and some will leak into the sovereign bond market.

Nevertheless, the economic and political risks in Europe remain on the downside. The PMIs may have stabilized but the forward looking new orders is still largely contracting. The austerity, uncertainty, and unusually cold winter in Europe underscores the poor economic outlook.

Given the relatively euro friendly news stream presently (even though Greece is unresolved) and short-term market positioning, which still seem short, even outside of the IMM, but the still negative outlook for the euro zone, it is best to think of it one step at a time.

Although I had favored a downside break from the congestion pattern. I recognized a break to the upside would target $1.34-$1.36. This still seems like a reasonable target. The other technical indicators I look at also do not appear to stand in the way of gains into that area.

Short-term traders may want to play for this move and may buy the next pullback in the euro, which should be limited to the $1.3130-50 area.

Medium term traders may prefer to wait for a better level to sell the euro. Look for reversal patterns, watch for the euro stops responding positively to good news (because it has been discounted) and market positioning (look beyond the IMM, as foreign exchange is ultimately a cash market and sometime the options market is helpful).

Marc Chandler

About 

Marc Chandler joined Brown Brothers Harriman in October 2005 as the global head of currency strategy. Previously he was the chief currency strategist for HSBC Bank USA and Mellon Bank. In addition to frequently providing insight into the developments of the day to newspapers and news wires, Chandler's essays have been published in the Financial Times, Barron's, Euromoney, Corporate Finance, and Foreign Affairs. Marc appears often on business television and is a regular guest on CNBC and writes a blog called Marc to Market. Follow him on twitter.