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Euro Breakdown Will Fuel U.S. Stock Breakout: Chandler

Jeff Macke

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Over the course of 2011, the idea that the euro is soon to become obsolete has gone from a crackpot theory to conventional wisdom. At least that's the way money managers are playing it, according to Marc Chandler, global head of currency strategy at Brown Brothers Harriman. "A lot of hedge funds, a lot of speculators, have been betting the euro's gong to fail," Chandler says.

Beware conventional wisdom. Despite, or perhaps because of the popularity of the "short euro" trade, the currency remains fairly resilient. To paraphrase the question being asked on trading desks worldwide: "What in the name of all that is holy is holding the euro up?"

Here are Chandler's three reasons:

1. European banks are bringing money home, whether they want to or not. It's all about capital requirements. The one thing European officials seem able to agree on is that banks need more liquidity. Forced to come up with more money, traders sell what they can, not what they want. Given the choice between dumping foreign debt into a weak market or selling liquid American assets banks will choose the former.

2. The dollar may be worse than the euro. "People are still worried about QE3 in the United States," says Chandler. Putting it less gently, America's ability to devalue the dollar actually exceeds the pace of the euro's organic demise. Ugh.

3. U.S. yields are still so low as to make buying our debt largely pointless. Chandler says when Americans invest overseas they buy equities whereas foreigners tend to favor our bonds over our equities. With an ever devalued buck, being long Treasuries literally cost foreign investors money.

All that said, Chandler thinks the euro will break to $1.29 versus current levels in the mid-$1.30s. Six cents may seem like nothing but it's a huge move in currency markets. As we've mentioned on Breakout roughly every other day since at least last April, "strong dollar = weak stocks." Chandler confirms the observation and uses real numbers to support it.

Using R-squared, 60-day rolling correlations and other wonky calculations, the currency guru says "the euro and the S&P500 are the highest correlated ever." While that implies a nearly catastrophic move lower in U.S. equities, history suggests that trade is half-again too obvious. We've seen "periods of inverse correlation in the past and we will see them again," he says. We better see inverse correlation soon or it's going to be a bumpy ride between now and the end of the year.

Can the buck move higher with stocks? Will the euro shock the world and make it through the Eurozone crisis unscathed? Are the S&P and the euro going to lock arms and jump off a cliff together? Let us know what you think!