The ECB is losing the currency wars

Earlier today I posted an article in the links on the euro’s move up to a 14-month high. As I write this, the euro is trading a 1.3568 to the US dollar, up markedly from 2012’s low during the sovereign debt crisis of 1.2063 on 25 July.

EURUSD 2013 01 29

And there’s a big reason for this.

Looking into my archives from that period, I see articles like “More on the euro disaster and current account imbalances” from Randy Wray on 17 Jul, “German – Spanish 10-year spread reaches record 610 basis points” from 20 Jul and “On Spain’s death spiral, regional bailouts and Germany’s ability to profit from crisis” from 22 Jul. It doesn’t take a rocket scientist to figure out that euro weakness is directly related to the sovereign debt crisis then. In fact, the euro bottomed on the very day that Mario Draghi announced that he would do “whatever it takes” and has since appreciated 15 cents to its present 1.35 level.

So, it’s clear that euro strength is inversely correlated with the severity of the sovereign debt crisis, something that presents euro policy makers with something of a dilemma.

Mohammed El-Erian said it best on Monday when he wrote that the ECB will come under pressure in the currency wars.

“The immediate solution to the euro’s existential problem came in the form of the European Central Bank’s “outright monetary transactions“. The ECB was supported by the progress made by governments in agreeing to reinforce monetary union with greater fiscal union, political integration and banking union.

Having solved its urgent problem, the eurozone needs to deal with a new dilemma: that of an appreciating currency. There is a growing number of countries seeking to weaken their own currencies. Indeed, in the last six months, the euro has appreciated by 11 per cent against the US dollar and by 8 per cent in nominal trade weighted terms. It has appreciated by a lot more against the Japanese yen.”

I highly recommend you read the whole piece. The implication here is that every country that can, the US, Britain, the Swiss, Japan, and Australia, etc, has a monetary policy that is conducive to a depreciating currency. These countries are either engaged in QE, intervening in currency markets to suppress their exchange rate or lowering policy rates, all monetary policies which weaken a currency. The ECB is the notable exception.

Because the euro zone’s institutional framework is geared toward tight money and an independent central bank, in a world of easy money we should expect the euro to appreciate unless the sovereign debt crisis flares. The interesting bit is that some investors like Jeremy Grantham were legging into European shares just as the currency was appreciating and shares were outperforming. That was a good strategy. Now that the euro has appreciated and bond prices have come down to reflect lower sovereign debt crisis stress, I believe we should see further outperformance in Europe when the currency translation is factored in. Rotation out of the US and into Europe should continue on this basis.

The problem for Europe is Spain. Because Spain’s deficit target is unrealistic, the country has taken on so much austerity that it is creating a debt deflation. I believe Spain will have to apply for an OMT style bailout at some point this year. If this happens as a result of a crisis that sees Spanish bond yields appreciating, then the euro and share prices will fall until the OMT is in place. But because the OMT exists, I believe that fundamentally, the euro zone’s government bonds should trade as quasi-sovereign currency bonds, with yields coming down over time. We should look for Spain to get a green light in relaxing its deficit target and/or formally requesting an OMT program as a good sign for European equities bond yields and the euro.

For now, as Spain is not yet in the hot seat and the crisis is subdued, the euro should continue to appreciate. And this will prove painful for the Spanish in particular, making an OMT request more likely.

Comments are closed.