Euro Continuing to Grind Lower

July 20, 2012

The relentless debt, growth, and banking crisis in the euro area has subjected the euro to a grinding downtrend but not a panicky sell-off.  The trade-weighted effective nominal euro index published on the ECB web site lost just 0.1% between July 13 and July 20.  It has fallen 2.3% so far this month, 5.4% since the end of 2011, and 19.3% in the 40 months since the start of the euro crisis in the autumn of 2009.  Against the dollar, the euro’s low earlier today of 1.2144 represented a drop of 3.8% since midyear.  It has declined by 5.5% this month relative to the yen and by roughly 44% from its 2008 peak.  The euro’s sterling cross this month has matched the drop against the dollar, as the U.S. and British currencies move more or less in tandem.

Confidence in the global economic outlook remains very depressed.  Ten-year bond spreads with Germany are still at currency union-breaking extremes that exceed 900 basis points in Portugal’s instance, hover near 580 bps for Spain, and surpass 475 bps in the cases of Ireland and Italy.  Two-year sovereign debt yields of 0.21% for U.S. Treasuries, 0.12% for British gilts, 0.10% for Japanese JGBs, and negative 0.07% for German bunds underscore the depth of the pessimism about economic growth prospects and the strength of convictions that 1) little will be done to improve the scenario and 2) that central bank rates cannot be raised during the foreseeable future without severely harming economic activity.  Japan’s overnight money rate target has not exceeded 0.5% since September 1995, and the Fed Funds target has been no greater than 0.25% for the past 40 months.  The Fed is publicly on record that the funds rate is unlikely to be lifted before late 2014.  I doubt a move will be made before the end of the next presidential term in January 2017

Investors face an extraordinarily difficult environment in which either to grow capital or protect asset value.  Diversification across asset types, maturity lengths and currency denominations is not merely a prudently good idea but a necessary tool of survival.   That said, diversification also has proven not to be an impenetrable shield, but it is a fact not to be ignored.  The call of portfolio diversification is a dollar negative, especially since the United States at best is the one-eyed economy in the land of the blind.  Viewed from this standpoint, a continuing downward grind of the euro still appears more probable than an all-out rout.

One of the signs to watch for that a more severe sell-off may be coming more imminent is pressure on the Swiss franc.  So far, Swiss authorities have been able to enforce their CHF 1.2000 per euro target ceiling.  If the Swiss foreign exchange policy were to become more costly than its perceived benefit, such would reflect a much more dire outlook for the euro in general.

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



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