ECB Holds Near-Term Key
August 24, 2012
What a difference a month makes! The euro hit a low for the move on July 24th of $1.2041, seemingly bent on a rendezvous with its June 7, 2010 trough of $1.1878. The experiment of a common currency, a one-size-fits-all monetary policy, but 17 autonomous fiscal policies was tangled up in a world of hurt with no politically feasible way to go forward. A recession in the peripheral members was spreading to the core nations, and a depreciation of the euro appeared imperative. Regardless of whatever other steps were taken, debasing the euro could lend general support to regional growth and bolster the competitiveness of the group’s most damaged members. The economic and political backdrop to the common currency’s fall from $1.2747 on June 18 and a 2012 high of $1.3486 on February 24 hasn’t really improved, but the euro has recouped slightly more than three-quarters of its five-week drop incurred between June 18 and July 24.
The ECB press conference of August 2nd was a catalyst behind this change in sentiment. ECB Pdt Draghi laid out conditional support for a much more active ECB role in reducing the long-term peripheral interest rates to manageable levels. Everything that Draghi has promised is highly conditional, and in that respect nothing really changed. Ezone politicians must implement painful reforms amid voter discontent, and peripheral governments must formally request help with important strings attached. There is no guarantee these prerequisites will be met. In fact, Euroland’s history of repeated broken promises to itself and others suggests the likelihood of an entirely different and more disappointing result. Certainly in the case of Greece, belief in compliance requires an enormous leap of faith by investors.
The rumor mill over the past month has encouraged such a leap of faith. It is reported that the 23 ECB Governing Council members will discuss a plan at its meeting on September 6 to target maximum long-term sovereign debt differentials between peripheral members and Germany through the purchase of peripheral debt. This is a whatever-it-takes approach, analogous to the Swiss National Bank’s policy not to let the euro weaken beyond CHF 1.2000. When governments and/or central banks undertake such unqualified policy goals, credibility becomes critical to success. Market participants must decide if officials are willing to pay whatever price is needed to enforce the goal and, more importantly, if ample means exist to carry out the verbal the promise. The British promise in September 1992 to keep the pound anchored to other European currencies failed because investors knew the promise could not be defended. The fact that the euro has recovered over the past month suggests that enough investors believe the ECB could end Euroland’s crisis and keep the common currency intact if they are prepared to do whatever it takes.
The mindset that the ECB holds the key to resolving the Ezone debt and growth crisis is ironic because the consistent message from Draghi and other central bank officials is that the heavy lifting must be done by others, that is the EU political leaders, European wage-earners and businesses, and the banks and other creditors holding EU sovereign debt. What the ECB decides is entirely conditional, and what central banks eventually do must also not jeopardize their fundamental raison d’etre of preserving price stability. One can conclude that the benefit of the doubt that has been supporting the euro over the past month is based on fragile assumptions, with perhaps an assist from the thinness of trading that characterizes the dog summer days of August.
That may not be all that’s going on. Even if all the ECB’s conditions are met, a weaker, not stronger, euro would be needed to ease the region’s burden and to reduce the risk to non-European economies that Europe’s unresolved difficulties pose. The fact that the euro can recover even temporarily from a shred of hope, rather than an approved credible plan reveals more about the dollar’s vulnerability than any intrinsically favorable properties of the euro. When all is said and done, the euro is the only viable currency to rival the dollar as a reserve asset. The yuan is too entangled in capital controls, and numerous impediments prevent the yen from performing any such role. Aside from doubts about the long-term integrity of the common currency, Euroland has chronically weaker growth than the United States and a stronger central bank commitment to low medium-term inflation. It is plain simple common senses to expect that the euro would be presently weaker than its lifetime average value against the dollar, yet it is not so. In fact, the euro is not much softer than its 2012-to-date mean of $1.2820.
U.S. political and policy uncertainties are huge, too. U.S. GDP and job growth norms are a shadow of what pre-existed 2000. The Federal Reserve is more unpopular and more distrusted than the ECB. The dollar since 1971 has a track record of debasement shared by other former international reserve currencies like sterling but not by the euro, Swiss franc, or yen.
It’s hard for EUR/USD to sustain a directional trend when other currencies are also trading in constrained ranges. The Swissy continues to move in lockstep with the euro because of SNB intervention. The yen remains in the high 70s against the dollar, not touching 80-something since July 6 nor moving beyond 77.9 this month. The kiwi has stayed close to 80 U.S. cents, and the loonie refuses to stray far from USD parity and is currently marginally stronger than that benchmark. The Australian dollar is firmer than central bank officials in that country would like, but they are not inclined to cut rates further in response.
The week ahead is crammed with a heavy data release schedule, including revised U.S. GDP, euro area sentiment, unemployment and consumer prices, and various Japanese indicators from consumer prices to industrial production, housing starts and retail sales. But the week’s main event will be the Kansas City annual central banking symposium at scenic Jackson Hole, Wyoming. Speeches there by Fed Chairman Bernanke and ECB Pdt Draghi are eagerly awaited, and it’s hoped that those speeches might be used to telegraph important central banking policy initiatives.
Copyright 2012, Larry Greenberg. All rights reserved. No secondary distribution without express permission.
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