Euro weakness changes the currency game

See the latest Australian dollar analysis here:

Macro Afternoon

Last year the EUR got down under 1.20 and I was convinced it was going to its true value, in my opinion anyway of 1:1 with the USD. Nothing against Germany or even France for that matter but the bolted on Eurozone area to these and other “core” nations really does make the sum of the whole worth a lot less than what a Deustchemark or French Franc would fetch in the open market.

Alas I got too bearish and Chairman Bernanke rode in in his helicopter and started raining US Dollars on the planet and that was the end of that. The USD weakened and EUR rallied all the way back to 1.4938 last week as the chart below shows.

Now it is a true measure of the impact of QE on valuations of the USD that against such a parlous Sovereign European Deficit and Debt position that the EUR was able to rally for such a sustained period and to such an extreme valuation.

Clearly this strength relies in large part on the strength of German resolve to both hold the Eurozone together and maintain the political will to keep stumping up the cash to bail out the Countries of the periphery, the PIIGS (Portugal, Ireland, Italy, Greece and Spain). In the old days we used to call them Club Med and I still think this sums them up better than PIIGS, although with perhaps the exception of Italy, they are certainly on the nose.

So far Germany has been able to hold the Euro together pretty well and has forestalled a Greek or Irish default. But writing in the Financial Times last night (that’s their cartoon up top) Martin Wolf suggests that a day of reckoning is approaching for the Debt laden periphery.

A story is told of a man sentenced by his king to death. The latter tells him that he can keep his life if he teaches the monarch’s horse to talk within a year. The condemned man agrees. Asked why he did so, he answers that anything might happen: the king might die; he might die; and the horse might learn to talk.

This has been the eurozone’s approach to the fiscal crises that have engulfed Greece, Ireland and Portugal, and threaten other member states. Policymakers have decided to play for time in the hope that the countries in difficulty will restore their creditworthiness. So far, this effort has failed: the cost of borrowing has risen, not fallen (see chart). In the case of Greece, the first of the countries to receive help, the chances of renewed access to private lending on terms that the country can afford are negligible. But postponing the day of reckoning will not make the Greek predicament better: on the contrary, it will merely make the debt restructuring more painful when it comes.

Given such a debt burden, what are the chances that a country with Greece’s history would be able to finance its debt in the market on terms consistent with a decline in the debt burden? Extremely small.

This is the key point in all this, as Reinhart and Rogoff have taught us, is that once the debt burden gets too big and the interest rate too high countries get caught in a spiral from which they struggle to drag themselves out of without a default. Look at Greece for example, EUR 110 bln last year and up to another EUR 50 bln in bailouts being propsed now.

Martin Wolf says,

What might persuade investors that this is sufficiently likely to justify funding Greece? Nothing I can imagine. But remember that 6 per cent would be a spread of less than 3 percentage points over German bunds. The default risk does not need to be very high to make this extremely unappealing.

In short, Greece is in a Catch 22: creditors know it lacks the credibility to borrow at rates of interest it can afford. It will remain dependent on ever greater quantities of official financing. However that creates an even deeper trap.

It seems that it is inevitable that Greek debt will be “restructured” thats part of why Standard and Poors down graded the Greek Sovereign rating to B last week and it should not be a shock to investors. But it won’t end there. Martin Wolf again

The saga is most unlikely to end with Greece. Other peripheral countries – Ireland and Portugal, for example – are also likely to find themselves locked out of private markets for a long time. In neither case is a return to fiscal health in any way guaranteed, given the extremely difficult starting points.

Overindebted countries with their own currencies inflate. But countries that borrow in foreign currencies default. By joining the eurozone, members have moved from the former state to the latter. If restructuring is ruled out, members must both finance and police one another. More precisely, the bigger and the stronger will finance and police the smaller and the weaker. Worse, they will have to go on doing so until all these horses can talk. Is that the future they want?

So far the EUR has managed to hold within 6 big figures of the recent high and sits at 1.4340 as I write. this is in no small measure because Europes present appears to be the United States future. But the EUR is not the DEM (Deutschemark) and their may be signs that the USD is turning (at least unless or until we see QE3) so we may be seeing a changing the currency game which has important global ramifications.

The troubles of the Club Med countries aren’t going away but if they are assisting in changing the outlook for the USD then they can actually be a positive. The world is simply too fragile for  a USD crash and the forces it would let loose in commodity and currency markets not to mention the inflationary impulse.

If the USD is turning then commodities (denominated in USD’s) should fall in the coming 6 months relieving inflationary pressures and letting central bankers off the hook. This should help temper the ECB’s inflation fighting vigor, reduce similar pressures in the developing world, especially China, and generally give any recovery a chance to gain more traction.

For the Australian dollar, the top is in medium term if the $US is turning, as I think it is. On the crosses – AUD/EUR, AUD/GBP, AUD/JPY – I expect that the positives that have accrued to the Aussie in the past six months will see it appreciate, especially against the euro.

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    • Deus Forex Machina

      Thanks Avid…I’ve been watching your blog and I like the appproach. Can’t seem to get my comments to post though.

      Feel a bit like a luddite 🙂

      • Common theme of those charts is that inflows and outflows of liquidity in the form of USDs is driving all the markets. I think confidence rather than the Fed is responsible for the amount of liquidity sloshing through the system at any point in time, but that’s a moot point. They key idea is that the direction of the USD trend is an important (maybe THE MOST important) driver for many markets.

        I left the comment settings at the google blogger default, assuming/hoping they would work. Have never actually tested it or tried to leave a comment myself. Will have a fiddle and see what happens.

      • Great comment Avid – agree 100%.

        I need to incorporate hourly charts better into my system, but don’t want to get too short term….but your charts have clearly shown a breakdown here.

        I’m watching the open today closely – down 50 points on the SPI futures so far.

        Banks have already been weak the last couple of days – might be time to add/start new shorts….

        • Deus Forex Machina

          I reckon you are right…Data Sword tells me that $43.63 is the big level for BHP this month…trend for the 2009 low. Certainly a bellwether to watch

        • Sounds about right – on the daily charts BHP has completed a head and shoulders, with an upward neck line. In the short term if that neckline is broken (around 44.70) its bearish.

          On the weekly charts, BHP is in a rising wedge formation (from November last year)with support at $44 even. A fall below that is very bearish.

          Target would be $38.

          • You’ve gotta entertain the possibility of a double top between May 2008 and last month. Or more likely a big new long term trading range.

            The trading range gives a target of $20, from the November 2008 low. The double top gives a target a long way below $20.

            As I’ve said before, anything can happen, and probably will.

  1. Armand Tamzarian

    “Now it is a true measure of the impact of QE on valuations of the USD that against such a parlous Sovereign European Deficit and Debt position that the EUR was able to rally for such a sustained period and to such an extreme valuation.”

    and peoples perceptions and selling of the USD seem to be based on them copping the monetary base numbers without bothering to see how much was being held as excess reserves(almost all of the “printed” money). Banks have not and will not lend this into circulation which is why inflation is low. Forex punters just don’t get it.

  2. “Chairman Bernanke rode in in his helicopter and started raining US Dollars on the planet and that was the end of that”

    Maybe so. How do you not know that the recent ‘bounce’ in the USD is not merely the speculators anticipating or even goading the Chairman to come through with the ‘goods’ in the form of risk free profits on whatever US debt the Fed is purchasing?

    Something like a halving in yields leads to a doubling of bond prices. Not bad even in a depreciating currency.

    • Deus Forex Machina

      the fed’s initial purchases and QE action actually saw rates rise in the US last year as the market anticipated the inflationary impact and the data was a bit stronger…this was counter to what the fed expected and bernanke stated years ago would be the effect of QE…

      what we see now with the rally in US treasuries in the longer end has more to do with the weaker growth profile and re-emergence of housing weakness than any fed purchses…IMHO anyway

      as for the idea about the specs…i’m not sure they are as clever or as big as you give them credit but if the Fed is ultimately forced to come back with QE3 we’ll be off to the races again

      • “the fed’s initial purchases and QE action actually saw rates rise in the US last year”

        Yeah but what did they do BEFORE the Fed’s initial purchases?

        And as I stated a couple of days ago in ‘Milk Money’, it may well be a “weaker growth profile and re-emergence of housing weakness” that causes speculators to smell blood in the water. They know the Fed & all central banks are good for it.

        The lack of an objective standard means market yields can fluctuate any which way speculators want to push them. I still say you need to recognise that the dollar is the obligation of its bank of issue, it is bank credit not a standard of measure of value.

        • Deus Forex Machina

          i think we’ll need to agree to disagree on this one…i see it as legal tender you see it as an obligation…since our money is not backed by anything i don’t see it as an obligation of the issuing central bank…but that’s just my view

          cheers DFM

  3. Debt levels in Europe cannot be compared to debt levels in the U.S., for example.

    Most European nations are not sovereign with respect to the currency and as a result you are not comparing apples with apples.

    It should also be mentioned that the work by Reinhart and Rogoff has been competely debunked by a number of different economists as it was a poor piece of work.

    • Deus Forex Machina

      not sure what you mean in the first point…debt is debt and has to be repaid…at least the yanks have the ability to drop their currency, increase inflation or default as greece and ireland are showing all they can do is screw their populations…

      as for debunking reinhart and rogoff…rubbish…the economic history of the past 900 years is there to be read…david hackett fischer wrote a book in 1996 called “the great wave” which essentially mapped the path we have taken and are taking…it is too early in the game to claim R&R are wrong…history is on their side and anyone who is claiming they are wrong is either being selective or using the last year or so’s bounce as justification against almost a millenium of history…

      not to put too fine a point on it 🙂

  4. In one of the last Max Keiser Report vids he spoke with a Greek representative who was also admitting that Germany would love a weak Euro to improve their terms of trade / export.

    Given the amount of basket case nations on the Euro (that we know of), I cannot help but think that there are some very tough times ahead for the Euro zone. Germany should go back to the DM.