Euro ends its first anus horribilis on a down note

Tom Tong03/Ιαν/2012Currency Updates

Our forecast for a short term stabilisation in the Euro held up rather well until the last Wednesday of 2011. News that an Italian auction had not gone well spooked the market, and the Euro dropped about 1% in a matter of seconds. Other than this nasty air pocket, trading in currencies was light and relatively trend less, as is typical of Christmas trading. The macroeconomic calendar was light as well, with the exception of a horrific report from the newly elected Spanish Government -more on that below. Other reports confirmed that the main trends from the last quarter of 2011 remain intact going into the new year. Europe, hobbled by wrongheaded macroeconomic and monetary policies, is sinking into recession. The United Kingdom is not far behind, and the United States remains relatively isolated from the disaster developing across the Atlantic thanks to its dependence on domestic demand and its relatively sane monetary policies. Unsurprisingly, US equities continue to outperform European stocks, and the dollar is slowly regaining its safe haven status.


Official production data continue to disappoint expectations, and a rather large gap has opened up between these and sentiment indicators. The later are more timely, but the former are what counts. Output in services, construction and industry was very weak in October. Services, in particular, dropped an unusual 0.7% mom. It is unlikely that things improved later in the quarter, given the steady barrage of negative news coming across the Channel. We think that the UK is already in recession, though this dip will be shallower and milder than Europe’s. We continue to forecast that Sterling will drop against the dollar by rise against the Euro, and expect another round of QE from the Bank of England in the first quarter of 2012.


The common currency appears to have stabilised somewhere near 1.30. We think that the main support for the common currency is still the extreme positioning in currency markets. Currency futures traders are overall short the Euro in record numbers, and the consensus of press reports and opinion makers is increasingly negative on Europe and its prospects. We think that this consensus is fully justified. The latest batch of terrifying macroeconomic news came out of Spain, where the new Government announced that the deficit target for 2011 would be missed by a large 2%, acknowledged that the country is again in recession, forecast negative growth for 2012, and announced yet another round of draconian tax increases and spending cuts to make up for this. Under pressure from Eurocrats, the failure of austerity policies is again being used to justify even more austerity. It must be noted that, of the major European economies, Spain has been the most faithful and aggressive implementer of the ECB austerian mindset. These policies have clearly failed, but the mantra from Frankfurt has not, and perhaps cannot, change. There are some positive signs in the Eurozone. Draghi appears to be intent on easing the strain on Government debt through the back door, by forcing Euro banks to aggressively bid on Government debt auctions; perhaps this is the best that can be done given German irrationality. However, it appears to be too little, too late. Peripheral economies seem to be in free fall, and only aggressive fiscal stimulus will stop the disaster. Since there is no chance of Germany agreeing to this, we maintain an overwhelming negative view of the Euro over the medium term. However, the common currency will probably derive some short term support from the enormous short positioning referred to above, which tends to be a decent contrary indicator when it is at extreme levels.


The US economy continues to decouple from the disaster developing across the Atlantic, and there is good reason to think this outperformance will carry on to the New Year. It is relatively closed, driven much more by domestic demand than by export performance. Also, the dollar is regaining its safe haven status thanks to the Eurocrisis, so it is likely that the inflow of capital will put even more downward pressure on rates. Finally, the hose construction sector is actually showing some signs of life, after a long four-year bust. There are some signs of a mild housing shortage in the US, and rental vacancy rates are now below long term averages. With mortgage rates at all time lows, it is possible that housing may finally provide some economic pull. The public sector will no longer be a drag, since austerity at the Federal level has disappeared from the radar, tax increases are unthinkable, and the state and local sectors seem to have finished their long, painful retrenchment. We remain bullish the dollar, and think that the recent trend of US equities outperforming the rest of the world will continue into 2012.


Written by Tom Tong

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