Euro’s Slide as Debt Crisis Continues has been Orderly

June 22, 2012

Major matters are at stake in the euro crisis that is now nearly three years old, and most people and institutions dealing with the mess have been cast in an unflattering light.  The broader world community, not just financial markets, are deeply frustrated with the European problem.  So all things considered, the key EUR/USD relationship has depreciated in a smooth and constrained fashion that will have but a muted effect on trade flows.  Much of the net change happened in the initial half year.  The euro recorded a quarterly average of $1.2726 in the second quarter of 2010 — that is roughly two years ago — and that was 13.8% weaker than its 4Q09 mean of $1.4762 just two quarters earlier.  At this writing, the euro is quoted at $1.2539, a mere 1.5% apart from its quarterly average from two years before.  To be sure, the euro has not traveled this 1.5% in a straight line.  Along the way, it spent the middle quarters of 2011 back above $1.40 and averaged $1.3236 as recently as February of this year.  The euro dropped this past week, setting June up to be the fourth consecutive month in which the euro on an average basis has depreciated against the dollar. 

Euro slippage against sterling has also been moderate.  In the earlier U.S.-centric world financial crisis, the euro in fact climbed 30% from an average level of 0.6847 per pound in 2007 to a mean value in 2009 of 0.8907.  In the final quarter of 2009, the mean slightly exceeded 0.9000.  In quarterly average terms, sterling recouped 5.2% between 4Q09 and 4Q10 but only 0.3% additional ground by 4Q11.  The euro’s pace of decline against sterling has picked up again this year.  At 0.8057 per pound, however, the euro is currently still slightly more than 17% higher versus the British currency than its mean value in 2007.

One finds the sharpest euro declines against the yen and Swiss franc, two monies that solidified reputations as “hard currencies” as far back as the 1970s.  From an average of 161.3 yen in 2007, the euro lost ground against Japan’s currency in each ensuing year, dropping to JPY 152.4 in 2008, JPY 130.4 in 2009, JPY 116.2 in 2010, JPY 111.0 in 2011, and JPY 99.4 so far this month.  The yen rose 65% versus the euro in the five years since June 22, 2007, an annualized gain of 10.6%.  The Swiss franc has also risen sequentially against Europe’s common currency in each of the past five years, posting a cumulative gain since June 22, 2007 of 37.8%, a 6.6% pace of advance.  There are many things related to the European debt crisis that world leaders need to fret about, but currency movement thus far hasn’t been one of them except for officials in Japan and Switzerland.  Not surprisingly, those authorities have subordinated demand management policies to pursue more stable currencies.

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From a currency market watcher’s perspective, a few developments stand out as one examines how the world economy has evolved since 2007 and looks ahead to what might occur in coming years.  One is the emergence of a Japanese trade deficit, which has cut the current account surplus substantially.  Except for a deficit in 1980 caused by the second OPEC-engineered oil price shock, chronic Japanese trade surpluses provided ever-present support for the yen.  China’s current account surplus has also narrowed sharply and is causing profound changes in the global flow of funds.

Neither diminishing Chinese surpluses, a chronically large U.S. fiscal deficit, nor a highly accommodative Federal Reserve policy has caused the dollar to plunge or domestic inflation and long-term interest rates to soar.  Those dire consequences were and continue to be predicted by many analysts.  It’s a misguided view of the future that disregards many pertinent facts.  Number one, U.S. government spending is in fact shrinking, having dropped 2.3% in volume terms in the year to 1Q12 following a decline of 1.1% in the year to 1Q11.  The budget deficit and run-up in fiscal debt were caused by a massive recession, not fiscal mismanagement, and the massive inadequacy of aggregate private domestic demand, public-sector spending, and net foreign demand is also the reason for receding inflation and historically low long-term interest rates.  Analysts who look for a widely different outcome disregard the experience of Japan and the 1930s depression.  They also ignore what’s happening in Germany, Britain, Canada, and even Japan.  Compared to their averages in the second half of 2011, ten-year sovereign debt yields have fallen similarly by 57 basis points in the United States, 56 bps in Germany, 55 bps in Canada, 75 bps in the U.K. and even 20 bps in Japan. 

The spike in peripheral EU interest rates is a poor guide for what might yet occur in the United States.  The problems of Greece, Spain, Italy, Portugal, and Ireland stem from their circumstances of belonging to a common currency area that was hard-wired with a number of fatal flaws.  The premiums in their sovereign debt yields reflect the possibility of massive currency depreciation and ballooning euro-denominated debt burdens should any of these economies leave the Euroland. Britain has a massive fiscal deficit and is back in recession, yet 10-year gilts are almost as low as bunds and well below the U.K. inflation rate.

Currency trading next week will be focused on the summit of EU leaders on June 28-29, where leaders with try to cauterize the crisis that threatens Spain and Italy.  It would be foolish given the history of the past three years to anticipate an agreement that will give the financial community back its confidence.  We’ve seen headlines that wowed markets for increasingly brief periods. Slowly, the view is setting in that the crisis cannot possible end without huge concessions from Germany.  The strategy thus far has subjected the likes of Greece and Spain to depression conditions, while the German economy enjoyed a good post-Great Recession run.  Now Germany is being sucked into recession itself, which may incentivize its government and central bank leaders to modify their hard line, but don’t count on that — certainly not by the end of this month.  If the debt drama drags on, more difficulties may await the euro.

In the U.S., the most important thing about next week — even more than the release of some telling statistics like personal income and spending, revised GDP, durable goods orders, and the Case Shiller house price index — will be that it marks half-time in 2012.  By week’s end, the fiscal cliff will be just six months away.  It’s not going to be addressed before the election, so markets will not be disappointed by a lack of progress next week or next month.  As the clock ticks down to December 31, the market’s atmosphere will be permeated with even more heavy-laden uncertainty than in the first half of the year.  Whatever happens in Europe, this doesn’t seem like the right time to make a giant leap into the arms of the dollar.  The June peak of $1.1878 per euro may get challenged, but more ambitious predictions like parity by yearend seem like an unreasonable leap of faith to me.

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

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