Two Big Opportunities in the Currency Market

If you weren’t paying close attention, you might have missed two back-to-back stories out of Europe that have the potential to reap big rewards for savvy investors. First, last Thursday, the European Central Bank surprised many traders by standing pat on its monetary policy, rather than taking action to weaken the surging euro currency. Furthermore, there weren’t even any hints that such a move might be coming.

ECB President Mario Draghi explained at a news conference that the euro’s recent rise has only resulted in a 40 basis point decline in inflation. In other words, there is little resistance to a stronger euro, so a shift in monetary policy was not required.

The ECB’s inaction caused the euro to rise by another two cents against the U.S. dollar. But the following day brought an even more dramatic move, after a surprising announcement that euro-zone banks will return 11.4 billion euros ($15.8 billion) to the ECB next week. That’s more than six times the amount that was expected!

Euro-zone banks will return 11.4 billion euros to the ECB next week.

The banks took the emergency 3-year loans in late 2011 and early 2012 in order to ride out a credit crunch. Many banks used the cheap funds to buy higher-yielding government debt from Greece, Spain and Italy. The fact that the loans are being paid back so quickly may be related to the expiring of short-dated Italian bonds earlier this month.

The move will result in a major downsizing of the ECB’s balance sheet, and a big decline in excess liquidity in the European banking system. Euro-zone banks now hold just 112 billion euros beyond what they need for their day-to-day operations, the lowest level since late 2011.

That drop in excess liquidity is also making traders increasingly bullish about the euro. Following news of the repayment, the shared currency rose to $1.3915 against the dollar, its highest level since the fourth quarter of 2011.

Click for larger version

And given the fact that the European Central Bank is unlikely to ease its monetary policy any time soon, we should see the euro continue to rally, possibly even approaching the $1.45 mark.

One good way to play that move is with the CurrencyShares Euro Trust (symbol FXE on the New York Stock Exchange), an ETF that tracks the movement of the euro currency.

In Japan, a Very Different Story

While the ECB shrinks its balance sheet, the Federal Reserve and the Bank of Japan are pursuing the opposite strategy. They continue to buy government bonds in an effort to spur their respective economies.

The Fed has finally begun to back off its quantitative easing policy, by slowly tapering the amount of its debt purchases toward $45 billion a month. But Japan is proceeding full speed ahead, printing about 7 trillion yen a month. In the last nine months of 2013, the Bank of Japan’s holdings of government bonds swelled by 50.3 trillion yen.

Bank of Japan chief Haruhiko Kuroda recently said that this aggressive QE policy will be scaled back in the months ahead. But Tokyo also plans to increase the sales tax from 5 percent to 8 percent in April, which is forecast to reduce Japan’s economic output by 4.3 percent in the second quarter. In order to counteract that expected contraction and minimize the pain, the BOJ will have to keep the easy money flowing, and devalue the yen against the Chinese yuan, the euro and the U.S. dollar.

Click for larger version

So despite talk of a stronger yen from the Bank of Japan, I expect the dollar to continue to climb against the Japanese currency over the next several months. From a level of 103.25 today, the greenback could easily approach 110 yen. In order to take advantage of this trend, traders should consider the ProShares UltraShort Yen ETF (symbol YCS on the New York Stock Exchange), which is designed to rise 2 percent for every 1 percent increase in the dollar vs. yen trade.

Best wishes,

Douglas Davenport