The European experiment (the creation of a monetary union in the absence of a centralized fiscal authority) is now reaping the rewards of breaking its own rules. Membership in the EU allowed profligate spenders like Greece to borrow at rates that were too low relative to their level of risk, and lax oversight, along with the use of derivatives, gave them the ability to leverage up their debt-to-GDP ratios above treaty levels. By doing so, Europe put its banking system at risk because it is the large commercial banks that hold much of the paper.
All that’s available to Europe now is to have the ECB print. Where do you think the money for the €700 billion, or €1 trillion (or whatever number is being talked about) backstop plan is coming from?
What’s been happening to the euro is nothing more than a good old fashioned currency crisis, which is defined as currency depreciation coupled with declining bond prices (and higher interest rates). That’s exactly what we’ve been seeing over the past several months because this rapid of a decline is a reflection of the fact fewer and fewer businesses and financial institutions were willing to accept euros in exchange.
Do you want to get paid in euros now? Neither do Europe’s banks (or their customers), which is why the Fed had to re-start its swap facility with the ECB.
European banks need dollars to complete more of their transactions, because euros are not being accepted as there is no way to hedge against a currency undergoing such a rapid decline. So, thanks to the Fed, the ECB can again swap euros for dollars and then lend the commercial banks all the greenbacks they need.
What this means in essence is that Europe doesn’t have its own currency at this time because the banking system can’t function using the home currency. And if that isn’t a currency crisis, I don’t know what one is.
With that being said, we may be seeing a shift in sentiment due to several factors:
- The ECB deciding to print and buy as much sovereign debt it can lay its hands on.
- The European sovereign debt backstop facility
- The Fed’s currency swap facilities
- European banks are generating profits (granted due to exceptionally easy monetary policies, but profits nonetheless)
The price action seen last week could be an indication of things to come. As the euro declined an astounding 5.58% from the peak on May 10, European stocks rose in all but one of 18 western European markets with the Stoxx Europe 600 Index rallying by 4.8%, the most in 10 months. At the same time, a measure of banks in the index gained 6.7%.
As the world was imploding back in the Fall of 2008 and the TARP (along with globally coordinated quantitative easing) were being implemented, the S&P 500 continued to trend down until reaching a bottom on March 9, 2009. From there of course we’ve seen about a 70% gain to April 26 of this year. What this shows is that coordinated and extraordinary actions by Central Banks and governments can support the system and cause rapid, strong growth to occur no matter to what degree things are disintegrating. And while this may seem somewhat obvious in retrospect, it certainly wasn’t the view when the global financial system looked as if it was falling into the abyss.
If you compare the Lehman collapse to the current European sovereign debt crisis, with the TARP being analogous to the €700 billion EU backstop facility, we may see markets react positively at a far more rapid pace exactly because investors have recently traded through a similar circumstance and have witnessed the eventual outcome. So, while I said on April 22 that the euro would move into the lower 1.20’s, after over 900 pips of depreciation what I’m saying now is that it’s time to close short euro positions and look for a bounce into the mid 1.25’s with an eventual move towards the lower 1.28’s.
This doesn’t mean that the euro can’t depreciate further; indeed, I believe that a declining euro is an essential element of the European plan. But the depreciation cannot be “disorderly” i.e. over 5.5% in one week, because it’s too destabilizing to the banking system.
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