A Watershed — or Perhaps Not

June 29, 2012

The paramount matter for currency market participants is whether Europe has turned a corner in resolving its sovereign debt and banking crisis.  Only a cockeyed optimist would deny that more setbacks lie ahead, but can it be at least concluded that an inflection point in the crisis has been crossed?  The answer requires a leap of faith, and one criterion that should not be used for guidance is the intensity of today’s response in stocks, bonds, commodities, and foreign exchange.  This is what markets do on a summer Friday when confronted with a substantial political surprise.  Expectations of a fiasco of a summit had been building all week long.  Officials instead were able to announce accords on a number of critical points — the recapitalization of Spanish banks, plans to promote growth, progress on a banking union and the empowerment of the ECB with greatly expanded supervisory authority and responsibility.

Many foundations of the problem have not changed. 

  • Growth prospects in the euro area remain extremely poor because of punitive long-term interest rates, elevated unemployment, the strong ideological push to cut budget deficits, and on-going balance sheet adjustments throughout the private sector.
  • Voter animosity between northern and southern Europe remains at a toxic level.  Centrist traditional parties on both the left and right are losing political support at the expense of more extremist, anti-euro movements. 
  • Greece must leave the tribe.  It should never have been admitted and has no conceivable way out of its uncompetitive predicament without a depreciated currency.  The $64,000 uncertainty concerns what happens to the rest of the common currency area after Grexit.  Investors have good reason to fear contagion.  Grexit has been averted for now but could still occur before yearend.
  • The resources for handling a full-blown crisis in both Spain and Italy are still lacking.
  • Germany continues to resist the idea of euro bonds and a transfer union and offers no plan to sharply reduce its current account surplus.
  • Europe’s demographic trends are very troubling from the standpoint of supporting social service programs, improving economic growth and managing public finances.

The history of the euro crisis also argues for caution.  Numerous political deals have been concocted before with great fanfare and, in many cases, when no accord seemed possible.  None of those previous agreements achieved an enduring improvement in peripheral sovereign bonds, and that’s the key weather vane that currency market participants should watch over the coming summer.  As recently as late yesterday, 10-year yields in Portugal exceeded German bunds by nearly 9 percentage points.  The comparable premiums approached 550 basis points, 540 bps and 470 bps in the cases of Ireland, Spain and Italy but was only about 15 bps for British gilts.  Such a disparity that punishes fiscally challenged euro members but not Britain represents insurance against a break-up of the euro and a vote of no confidence that politicians will find a non-market solution to correcting Euroland’s present imbalances. 

Put differently, a European crisis continues to exist as long as the markets think it hasn’t ended, and market opinion will be best read from the premiums of long-term sovereign yields.  If these fail to collapse dramatically or soon begin creeping higher, currencies, equities, and commodities will draw the conclusion that today’s actions still fall far short of what must be done.  Instinctively, I believe that this is how events will play out in July, and people will look back on today as an opportunity to sell euros at levels they didn’t expect to see again for much longer.  Whether such pessimism will be borne out in the future hinges on future political decisions and other uncertain variables.  At this juncture, therefore, it’s good to take stock of what else has happened in 2012.

The dollar advanced against a broad range of advanced economy currencies in the second quarter, not just the euro. The Swiss franc has been glued near to the Swiss National Bank’s target ceiling of 1.2000 per euro, so the two move in tandem on a daily basis.  Sterling has fallen less than half as far as the euro, and so have commodity-sensitive currencies like the Canadian, Australian and New Zealand dollars.  One of the year’s most surprising developments is that these currencies also dropped much less than commodity prices, especially oil, and it may be that the second half of the year may see that disparity reversed at least in part.  Emerging market currencies have faired considerably more poorly than those of advanced economies.  Even China’s yuan has relinquished some modest ground. 

The strongest G-7 currency during the second quarter was the yen.  In some respects, that’s an unexpected move.  The ruling coalition wants to double Japan’s sales tax, a move that risks a sharp slowdown and seems a dubious way to cut the government’s massive debt.  The Japanese trade position has swung to deficit from decades of being in surplus.  Japan nonetheless is at a better cyclical spot than Europe and doesn’t carry the unique baggage of the dollar.  One would expect the euro to be weaker now than its lifetime mean against the dollar.  It isn’t, and the continuing failure of the U.S. currency to strengthen past 1.2000 per dollar says more about its negative aura than about any intrinsic appeal of the euro. 

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


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