Big Storm Coming and No Place to Hide

May 18, 2012

The euro’s increasing vulnerability is the main topic of currency market chatter.  It has taken 2.5 years for the euro to depreciate about 23 U.S. cents or some 15%.  Over this span, a familiar sequence of crisis intensification, slow policy response, and eventual announcement of measures to preserve the euro has kicked the problem down the road.  The euro has bled slowly in the process.  The threat to the currency union now looks more immediate and dangerous, and the catalyst for this transformation over the last few weeks came from voters declaring that enough is enough to an endless layering of failed austerity. 

Some analysts are calling the coming juncture another Lehman moment, not because of the immense implications for Europe but because damage is unlikely to be contained to that region alone.  U.S. Treasury officials, who permitted Lehman to die, could only estimate the consequences of their exercise in tough love, and they guessed wrong.  The aftermath of Greece leaving EMU, which is what I expect to happen, is a wholly different event than the collapse of Lehman, but the market response and impact on other regions of the world is similarly unpredictable to the earlier event.  It’s a roll of the dice.

If Europe’s crisis becomes a problem for North America, Japan, and emerging markets, the euro’s depreciation should be mitigated in size and duration against the dollar, yen, Swiss franc, and currencies of commodity-sensitive economies and emerging markets.  Europe’s stress points would not have been exposed and rubbed raw without the earlier U.S.-ignited financial meltdown.  America paradoxically suffered less than Japan or Europe in the ensuing Great Recession.  One can similarly conceive of a chain reaction starting in Europe but mutating eventually to penalize other economies with equal ferocity.  It will take some time for such a transfer to unfold completely, and in the meantime, the dollar seems likely to eclipse its June 2010 high-point of 1.1878 per euro.

No acceptable crisis resolutions for Europe remain.  Creating a common currency union in the heart of Europe was among the greatest misjudgments of a mistake-filled century.  The promotion of lower inflation was a pyrrhic victory, since by almost all other measures, economic and geopolitical well-being have suffered under EMU.  Letting Greece abdicate carries enormous near-term risks, but long-term survival of the single currency will only be secured with a degree of political and fiscal union  that governments and their people will probably not accept.  Furthermore, it’s getting harder and harder to secure interludes of calm while EMU stays intact.  The mission of fixing the European debt and banking crisis with Greece locked into the Ezone strait jacket is unlikely to get accomplished in five, ten, twenty-five or even 50 years.  The likeliest way back to normalcy involves a full or partial break up of the common currency.  

Pro-austerity forces are powerful and equally misguided in America.  It is a misconception that high public debt in many advanced economies will lead to painful elevation of inflation and long-term interest rates.  The examples of Greece, Portugal, Ireland, and Spain are red herrings when applied to the United States or   Japan, where debt now exceeds 200% of GDP.  The average 10-year Japanese JGB yield was 4.91% in 1988-89 and 5.44% in 1990-94 but shrunk to 2.29% in 1995-99, 1.38% in 2000-04 and 1.60% between the start of 2005 and the onset of the world financial crisis in August 2007.  The table below of period averages in 10-year sovereign debt yields since 2008 further showcases how the loss of proper self-sustaining normal financial market functionality in recent years has had a greater deflationary than inflationary effect on long-term interest rates.  The figures are calendar year averages and, for 2012, the year-to-date mean.

10Yr, % 2008 2009 2010 2011 2012
U.S. 3.65% 3.24% 3.19% 2.76% 2.00%
Germany 4.00 3.27 2.78 2.64 1.81
Britain 4.49 3.60 3.52 3.00 2.12
Japan 1.49 1.35 1.18 1.12 0.96

The drop in long-term interest rates and share prices has been very pronounced over the past two months, which is hardly surprising given intensifying risk aversion.  Since March 19, the 10-year U.S. Treasury yield has dropped 62 basis points to 1.75%.  Comparable asset yields have fallen by 63 bps to 1.43% in Germany, 61 bps to 1.82% in the U.K., and 21 bps to 0.83% in Japan.  Equities have tumbled 15.1% in Japan, 12.3% in Germany, 11.6% in Britain, and 6.1% in the United States.  Oil prices have slumped 15.0%, and gold costs 4.6% less to purchase. 

The relative appeal of major currencies will become murkier next year.  Two economic issues hold center stage in this year’s U.S. election, unemployment and public debt.  The former exceeds 8%, and the latter (slightly above 100% of GDP) exceeds the relative size of Euroland debt.  Voters have been told that joblessness is high because government is too big.  But when fiscal restraint shoots higher under President Romney, the immediate effects as in Europe will be to reduce growth and inflation, and not to cut the public-sector deficit as much as planned.  Fed policy might be eased as a counter-weight and certainly will not get tightened.  Very low long-term interest rates will persist.  All these developments imply a softer dollar, and officials in Japan, China, and emerging markets will not remain idle spectators watching the euro and dollar slip lower.  Currency valuation will be a greater policy consideration next year than it has been in 2012. 

Copyright 2012, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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One Response to “Big Storm Coming and No Place to Hide”

  1. Hello ..

    I like to share my technical view with all
    great traders here ..

    Actually from a swing trading point of view i am waiting the weekly close under the last bottom in January 2012 .. if the EUR / USD closed below that bottom i expect to see 1.2000 – 1.2200 ..

    Here is my chart ..

    http://postimage.org/image/wb068u9w3/

    Hope you all the best

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