It’ll be an explosive weekend for the euro – but my outlook is bullish

In the USA, markets are closed today for Independence Day celebrations. The occasion is observed every year with lavish fireworks displays all over the nation. And by an exquisite coincidence, the Greek referendum this weekend promises its own brand of fireworks in the eurozone.

All eyes will be on the result of this particular vote, and most market observers expect a violent reaction either way when markets open on Sunday night. This weekend, there will be explosive displays globally.

And what a way to mark the historic war which is currently taking place in the financial markets – the war between the inflation of debt and its deflation.

In recent years, the global economies (and private households) have been sustained on ever-larger debt obligations. Interest rates have been pushed to the floor by central bank policies, making the debt seem ‘affordable’.

Below is a revealing chart showing the massive growth in household debt in Australia and Canada. Both countries have experienced massive housing price bubbles with prices rising fast while incomes have remained stagnant.  Debt has exploded.

Household debt chart - Canada & Australia

 

Chart courtesy elliottwave.com

The law of financial gravity may be about to kick in

Have we reached a ‘Wile E Coyote moment’ – when lenders and borrowers, suspended in mid-air, look down and see the enormous drop to the canyon floor?  In true Looney Tunes fashion, reality suddenly strikes, and they begin their descent as the law of gravity inevitably takes over proceedings.

Maybe this weekend will be that moment – no-one can say with certainty.  But it would certainly be a fitting moment for the law of financial gravity to finally swing into play after years of suspension in a make-believe debt bubble.

Whatever the outcome of the Greek referendum, the nation is bankrupt. The basic question is this: does Germany want to throw even more good euros after bad, knowing that repayment would be virtually impossible?

That issue is the microcosm of the larger question of the inflation/deflation battle.  If we are really on the cusp of a deflationary phase, then asset prices that have been elevated by debt are extremely vulnerable.

We are already seeing that in the collapsing Shanghai stockmarket index – another market that has been pumped up by enormous levels of margin debt.  Panic selling has sent the index down 5% overnight, within 30 minutes of opening.

So my next question is this: is Shanghai a foretaste of things to come closer to home?

Previous market jitters have been met by more central bank ‘support’, but with the US and UK opposed to further QE and rates at rock bottom, they may have run out of ammo.  And even if banks do rush new rounds of QE in a panic reaction, it won’t necessarily stem the tide of selling. Has the ‘Buy the Dip’ brigade finally met its match?

Once social mood switches from bullish to bearish – a process that is taking several years – nothing will stop the purge of over-leveraged positions.

That’s when the fireworks will look more like a hydrogen bomb.  And that’s when cash will be king once more.

‘Grexit’ is bullish for the euro

Most believe that Grexit, which must be inevitable at some stage, is bearish for the euro. I disagree – it will be very bullish, at least for a time.  Greece has been a black hole for the various ‘loans’ (in reality, they are fiscal transfers). And with that weak link removed, the euro will be backed by the stronger nations and will fare better against other currencies.

But what do the charts offer as clues?  Here is the daily chart:

Euro spread betting chart

The long and strong bear move to the March low was my wave 3, and since then, the market has been in rally mode in a complex wave 4 (which I warned against back in March).

But note the lovely wedge pattern now forming with my clear Elliott wave pattern within.  A textbook wedge has these five waves (not to be confused with a ‘motive’ five wave pattern) with the fifth wave breaking out as shown. The key to this scenario is a break of the upper wedge line – that is the level to watch.

Below is the current hourly chart:

Euro spread betting chart

Following the knee-jerk reaction to the Greece referendum news on Monday morning, the market gapped down. But cooler heads prevailed and the market rallied strongly (off my wedge line) before settling down again.  The tug-of-war was on.

But this week’s decline was another test of my wedge line (green) and held at the Fibonacci 78% before staging its current rally phase.  I have tentative tramlines drawn and this morning the market has pushed up past the upper tramline.  This is all potentially bullish action and is helping to confirm my bullish outlook.

Finally, bullish sentiment towards the euro is low. This is reflected in the latest Commitments of Traders (COT) data.

Non-commercial Commercial Total Non-reportable positions
long short spreads long short long short long short
CONTRACTS OF €125,000 Open interest: 345,427
Commitments
67,867 167,173 5,022 233,162 101,253 306,051 273,448 39,376 71,979
Changes from 16/06/15 (Change in open interest: -4,718)
-14,847 -4,898 531 7,350 -1,588 -6,966 -5,955 -2,248 -1,237
Percent of open interest for each category of traders
19.6 48.4 1.5 67.5 29.3 88.6 79.2 11.4 20.8
Number of traders in each category (Total traders: 238)
61 87 30 52 62 127 166

 

The speculative money is still lined up massively on the short side, and interestingly, the commercials (smart money) actually swung to a more bullish stance in the most recent week.

I am sure I will have some interesting developments to discuss in next Monday’s article.