If history repeats itself, and the unexpected always happens,
how incapable must Man be of learning from experience?
-George Bernard Shaw (1856 - 1950)
Just when we thought our economy was in a shambles, along comes
Europe to bring us cheer. Could it be that we are not the Biggest
Loser?
The European Central Bank (ECB) got a lot of kudos last year; they
were lauded as the defenders of the faith, fighting inflation,
being disciplined and preserving the value of their currency. The
Fed and Treasury supposedly had us on a reckless road to
hyperinflation and a worthless currency; they might still prove
their critics right, but the ECB no longer gets any accolades.
Europe's economy is imploding at an accelerating pace. Output and
sentiment are plummeting; Greece was downgraded to A-, while
Portugal, Spain and Ireland are on ratings watch. The ECB cut rates
by 0.5 percent to 2 percent last week, but stated the rate was
consistent with a more pessimistic outlook, implying it would take
even greater economic deterioration before they cut rates further.
The market thinks the ECB is behind the curve and in denial. They
believe rates need to fall to 1 percent or lower. European banks
have been less aggressive in recapitalizing themselves and many
have lent large amounts to Eastern and Central Europe. As those
regions deteriorate, Europe's banking system looks even more
fragile.
The EUR poses a special problem; prior to a single currency,
countries that were struggling were able to devalue their currency,
boost exports and partially offset domestic woes. Not any longer.
However, while they do have a single currency, they continue to
have separate and distinct bond markets. With the recent ratings
downgrades, spreads have widened relative to Germany, which raises
borrowing costs for those countries that can least afford it. An
unhappy situation all round.
Not surprisingly, the currency has struggled. It has fallen by over
8 percent vs. the GBP since it peaked around 0.98 at the end of
December and by 30 percent vs. the JPY since August 2008. As the
attached chart shows (
click here),
the USD has gained vs. all the major currencies between December
18, 2008 and January 16, 2009, with the EUR being among the
weakest.
Is the EUR doomed? There have been rumblings (yet again) about a
break up of the EMU. Some have the weaker Southern European
countries exiting so that they can devalue their way to prosperity,
while others talk about one of the "pillars" of the EMU walking
away so as not to get dragged down with the rest. The probability
is low, at least for now; it would involve all sorts of legal
complications, as the treaty does not have a pre-defined exit
process. Any talk of an exit by one of the weaker countries would
cause their borrowing costs to rise dramatically, as bondholders
would demand additional risk premium. A sudden devaluation of their
legacy currency vs. the EUR would have the same impact on
bondholders of a partial default and an actual default might follow
once they are outside the EU support structure. The problem
confronting many of those countries is a lack of fiscal discipline;
currency devaluation is not a magic potion to cure all sins.
Before we write off the EUR and predict a fall to parity (or worse)
vs. the USD, let's keep in mind a few positives. Europe's housing
market is in relatively better shape than in the U.S. and Britain,
with less leverage and less dependence on securitization. They have
never had a Fannie Mae or Freddie Mac, which is a boon when you
consider what has become of them and what their future holds.
Consumers are similarly less indebted, as are governments, though
deficits are rising rapidly and will continue to for some time.
Having said all that, the currency will continue to underperform in
the near term. U.S. rates can't fall below zero, which is
essentially where they are, so any anticipated or actual fall in
EUR rates will be a drag on the currency. Concerns about Eastern
and Central Europe, ratings downgrades and EMU break up talk do not
help, nor does the general mood of risk aversion, which keeps money
flowing into U.S. Treasuries and out of the Euro Zone. Even when
risk appetite improves, the benefit will largely accrue to
currencies like the AUD and BRL, as those economies are perceived
to be in a better position to rebound quickly.
I remain negative on the USD for the second half of 2009, but the
EUR will benefit less than other currencies. I think the EUR could
trade down towards 1.15 over the next couple of months. At that
point, it probably offers long-term value and I would expect to see
a slow recovery towards the 1.35 area by the end of the year. My
earlier projection had been a rise to 1.50 by year end, but the
deterioration in the European economy makes that far less likely.
The EUR is a reserve currency and will remain relatively stable,
but with inflation falling and the economy weakening, the ECB will
implicitly bless a weaker currency, to prop up its economy and
silence some of the EMU naysayers.
Looking Ahead
It is remarkable that the dollar has managed to gain vs. most
currencies last week, despite the economic data we saw. The
employment number was terrible and retail sales and industrial
production were shockingly weak. The TIC data showed that investors
sold Treasury, agency and corporate debt in November. However, risk
aversion continues to bolster the USD as short-term ("hot") money
flows into Treasuries. Both the USD and GBP are also benefiting as
predictions of rate cuts elsewhere are seen as narrowing interest
rate differentials that currently work against both currencies.
I do not expect a lot of direction or insight from a
holiday-shortened week and light economic calendar. The EUR will
remain weak, with 1.30-1.35 the likely range. The JPY has bounced
off its strongest levels around 88.50 on fears of BOJ intervention
and a realization the economy is weak. It should stay around 90, as
any weakness will be capped by risk aversion. Expect some
improvement in sentiment and perhaps a stock market bounce
following Tuesday's inauguration, which might lead to a minor
dollar sell-off and bounce in commodity and EM currencies. None of
this changes my longer-term expectation of a weak dollar, a
struggling EUR and an outperformance by commodity and Asian
emerging currencies, once global growth stabilizes and risk
appetite returns.