European Fiscal Problems Won’t Fade
April 30, 2010
Currency market trading next week will be dominated by the scramble to rescue Greece. Outside aid for that heavily indebted economy has been misplayed repeatedly by just about everyone involved in negotiations, and the euro has paid a price for that indecision. Investors cannot avoid comparing attempts to rescue Greece from sudden default to the events preceding the failure of Lehman Brothers. Exploding sovereign debt — collateral damage from successful attempts to avert a world depression — is not limited to Greece or the euro area, so Greece’s present predicament is a later manifestation of the profound adjustments that claimed Lehman Brothers earlier. What makes Greece and Euroland different from the United States or Britain, which also saw fiscal deficits and debt soar, is the rigidity of sharing a common currency that prevents the best remedy for sovereign debt problems. Because no legal provision exists for Greece to leave the currency union and devalue its currency, few investors doubt the inevitability that Greek debt will be restructured eventually. That is a matter of when, not if, and so is the matter of contagion to the euro area’s other perceived weak links.
The euro has nevertheless been trading as if the debt problems of Eurolands peripherals are a short-term problem only. Headlines that suggest a big aid package will be approved next week lift the euro, as if the problem would then go totally away which it of course will not. When the headlines turn ominous, the euro falters as investors hedge against a Lehman-like resolution. The week ahead will offer a fair share of worrisome headlines, protests in the streets of Athens and on floor of Germany’s parliament, but a decent ending remains possible. The euro’s 13.4% fall from $1.5149 in late November to a low of $1.3116 this week was very steep, amounting to almost 30% annualized, but the present level of the EUR/USD appears still too high for a currency whose frame is cracked but with no recall procedure to get fixed properly. At $1.3283, the euro is only 2.9% weaker than its year-to-date average and even closer to its mean value of $1.3473 during the second five years of its existence. In the euro’s initial five years through 2004, it averaged $1.0350, by comparison.
Purchasing manager indices next week will confirm that the Euroland economy, like those of the United States and Japan, continues to improve from most standpoints. Aggregate demand, confidence, production and financial market functionality are all trending better. The last of these items, however, is endangered by the substantial Greek and Spanish loan exposure of French and German banks. No matter what gets done about Greece, it is much easier to imagine a further erosion of the euro than a rebound to $1.40 or better. And not coincidentally, the big holders of U.S. dollar portfolios in Asia and OPEC aren’t making public threats about diversifying away from the U.S. currency into the euro as they had been doing during 2009.
A second major focus next week will be Britain’s parliamentary election on Thursday. Conservative leader Cameron won the final debate according to the instant polls, but nobody knows if a burst of momentum late in the campaign will enable his party to a secure a working majority of parliamentary votes. Once the Liberal Democrats emerged as a viable third contending party and not just a vehicle for protesting Labour-Tory politics as usual, the specter of a hung parliament unable to fashion short- and long-term plans for restoring the budget to a sustainable path made investors edgy about sterling. The currency was already considered quite depressed especially compared to levels last August. The perception of under-valuation helps explain why the pound may eke out a small net gain against the dollar for April. Without the euro facing even more pressing problems, a sterling uptick would probably not have happened. Sterling’s prospects will be clearer once the composition and competence of the next government are known.
This was a very good week for gold, which is a positive omen for the Swiss franc. Swiss monetary authorities have moved their line of defense to 1.433 from 1.50 per euro during much of last year. The new policy appears more flexible because deflation is less plausible in light of upwardly trending world commodity prices. If British elections produce an inconclusive result and Euroland officials fail to fashion a deal beyond a short-term remedy for Greece only, investors may turn their sights to the franc as a refuge for retaining a presence in Europe. Players will scrutinize ECB President Trichet’s statement and press conference on Thursday for indications that monetary policy can avoid being subjugated to assisting the region’s fiscal difficulties.
Japan is immersed in Golden Week and will not open again until Thursday. With its very low long-term as well as short-term interest rates, the yen continues to be an inverse barometer of risk appetite. If efforts fail to produce a credible support package for Greece, the yen will be tugged in two directions. If wider tremors in world financial markets follow, the yen could draw some support in the pattern that was seen during 2007-9. But Europe’s fiscal problems have refocused attention on Japan’s debt, which is the world’s highest as a percent of GDP. Against the dollar, the yen has quietly retreated by six yen from 88.15 in the first week of March to 94.15 currently. Moving past 95 per USD would be an important milestone, but the 100 level carries considerably more symbolic importance. The 100 per USD level has not been breached since mid-April 2009.
Commodity currencies ought to be performing well, and the Australian and New Zealand dollars did move higher both last week and for April as a whole. In Canada where the economy is gathering steam and the central bank seems poised to raise rates in July, if not early June, the loonie fell more than 1% against its U.S. counterpart last week and ended up close to its end-March level. Parity with the dollar has produced considerable resistance each time Canada’s currency appreciates into the high 0.90s. An axiom of currency trading is that when an important level repeatedly cannot be taken out, a corrective reversal of the main trend ensues. I continue to believe that Canada’s economic and financial fundamentals are too good for the trend to be halted at par, and that Canadian officials would not resist a further appreciation of their currency. If the loonie continues to hover at parity in May, the decision to lift interest rates in early June will be easier. Such would be an important reality check for Canada’s currency upward potential.
Copyright Larry Greenberg 2010. All rights reserved. No secondary distribution without express permission.