Quo Vadis, Euro?

Tom Tong16/Μαΐ/2011Currency Updates


The common currency has been on a tear since bottoming out below USD1.20 last year, at the height of the initial phase of the peripheral crisis. The decision to first bail out Greece, and then set up a permanent bail out facility for other stricken sovereigns, combined with the generalized sell-off of the dollar against most currencies (brought about by the Fed’s decision to start another round of Quantitative Easing) has brought it to its recent highs of nearly 1.50 USD. Last week’s commodities crash, dollar rally and reappearance of the peripheral problems as it becomes clear than Greek cannot pay its debt, have knocked it down to around 1.44. Even there, however, it sees above the recent year’s average and most estimates of Purchasing Power Parity with the USD.

Two key issues that will drive it going forward:

1. Interest rate differentials

This has been the key factor in the rise of the euro over the last year. The Federal Reserve has been consistently more dovish than any other G10 central bank – save perhaps for the Bank of Japan. First, last year it decided to launch another round of Quantitative Easing, whereby the Fed expands its balance sheet by buying treasuries in the market and flooding the banking system with dollars. Furthermore, Ben Bernanke has been consistently dovish, pointing out the s

luggish nature of the recovery, the still high levels of unemployment and dismissing the rise in headline inflation as a transitory consequence of the rise in commodity prices.

By contrast, the ECB dropped a significant surprise in the market in the March meeting, announcing that the ECB was ready to start hiking in response to heightened inflation pressures. The rate differential between short term euro rates and short term dollar rates widened significantly, and the EUR rally got a new leg (see chart below):

The white line depicts the difference between the expected short term rates in Euro vs the United States, whereas the red line is the EUR/USD exchange rate.

Future moves: the ECB is clearly itching to hike rates. Should it follow through with its threats, we would expect the euro to continue rallying. The main risks are: a new blow up of the peripheral countries, particularly Spain, which would make it very difficult for the ECB to carry out a full hiking cycle and a slowdown in the German export machine, which has been propping up the core countries’ economies even as consumer spending disappoints all over Europe. The next critical date is the July meeting: failure to hike rates at that meeting would be bearish for the euro. In the meantime, any tape bombs regarding the troubled peripheral countries would cause the euro to swoon.

2. Peripheral troubles

With Ireland, Portugal and Greece having thrown in the towel and asking for a bailout, the main focus now switches to Spain. The previous bailouts have been (so far) manageable due to the relatively small size of their economies. Not so Spain. While their level of government debt is still relatively low (expected to rise to 70% of GDP in 2011), the big worry is the Spanish banking system. After experiencing a massive real estate bubble, it is not clear exactly what losses the banks are carrying in their balance sheets and past efforts on the part of the Bank of Spain to assuage markets have not been wholly successful. On the positive side, it seems that markets are now differentiating between Spain and the other troubled peripherals (see chart). On the negative side, the Spanish economy does not seem to have bottomed out. Unemployment has not only reached alarming levels, but it has (almost uniquely) failed to find a top and continues to rise. Further, credit appears to be cut off for anything other than purchasing apartments that the banks carry in their balance sheets.

10-year rate differentials between peripheral government bonds and German bunds

Future moves: The stabilization of the peripheral situation would probably require: a realistic haircut for the size of Greek debt; lowering the rates charged in the loans to Portugal and Ireland and a relaxation of the drastic austerity packages and real signs of an export-oriented economic recovery in Spain. Should this take place, it would remove much of the downside tail risk from the euro and we would expect it to soar to new records.

However, a disorderly Greek default or exit from the euro, and/or a loss of confidence in Spain’s ability to grow its economy, increase exports and service its debt would probably force Spain into the arms of the IMF/EFSF. This would almost certainly be disastrous for the euro, and we could well revisit last year’s low fairly quickly.

Big bank forecasts:


Written by Tom Tong

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