Monday, January 11, 2010

Euroland Crisis

We had a mini-currency crisis in late 2008/early 2009, when many currencies (Canada included) dropped about 20%+.


This currency crisis turned out to be relatively benign in most cases, not all, since it was accompanied by a credit crisis. The deflationary impact of the credit crisis and falling commodity prices meant that this currency crisis was actually welcomed by many countries, as it cushioned some of the impact of deflation. The massive collapse in global trade meant that many countries welcomed the falling currency.

Take Canada: Our loonie dropped to 77 cents, approximately 20 cents down from its summer 2008 levels. The Bank of Canada and many exporters were happy with this currency devaluation since it gave a temporary cost advantage to Canadian exports. In a normal situation, a 25% drop in the loonie in 2 months, may have called for emergency measures, including rate increases and would have caused the inflation rate to increase.
Despite the worries about Greece, the Euro remains quite high at $1.45, off from its $1.60 from 2008 and $1.51 in late 2009.

Why do we care about Europe? Besides being a huge economy that rivals the US, depending how you measure it, it has another impact. The Euro is 57% of the widely followed US Dollar Index (this weighting makes little sense but I digress).

A large drop in the Euro in the summer of 2008 preceded the Crash of 2008 by about a month. The Euro fell and so did commodities (as they are often correlated). At first, misguided bulls claimed that this was good as they wanted $147 oil to come down and lead the way out of the slowdown (what recession?). The Euro was dropping like a rock (from 1.60 to 1.45 from mid July to Labor Day). Pundits at the time claimed that this was because the European economy was slowing and rates were going to fall. Whatever, the reason, the rise in the US dollar was powerful and part of a cycle of a rising US dollar and falling asset prices. There is a ton of US debt out there, and when the US dollar rises, it makes that debt more expensive. Especially in 2010, the US dollar is a funding currency with 0% interest rates.

I believe that the Euro currency never made sense but needed a crisis to show this. The logic of the Euro is the following:

The strong countries (Germany, France) benefit since they no longer have to worry about the so-called PIGS (Portugal, Italy, Greece, Spain) devaluing their currencies against them, which would hurt their huge export driven economies. The PIGS and others benefit since they can easily borrow in a stable currency, the Euro, and hence, at lower interest rates. Win-win.

The problem: To greatly simplify, the PIGS took advantage of the lowest interest rates in their lifetimes to run up debt and in some cases, pile into housing. PIGS have lower standards of living, higher debt loads and higher inflation and yet a one size fits all currency and interest rate structure was the prescription.

The less efficient PIG economies have no way out of the current recessions. They can't cut interest rates (they are already near zero), they can't devalue anymore and most importantly, they can't spend their way out (the EU has strict rules on deficits, and these countries have massive structural deficits and looming funding problems). They have to do the opposite: cut spending and get their house back in order, which is a sure-fire recipe for union troubles, riots and social unrest, not to mention instant dismissal at the polls. The Euro is very unpopular as the cost of living in Euros is expensive in these countries.

The EU is not a country and as such, there is no national identity, no mechanism for bailouts between countries nor are there any transfer payments between countries.

Greece will be the test case, as they need to borrow over 50 billion Euros in 2010 and it is possible that they will not be able to do it via the bond market. If so, they may need to go to the IMF or the EU. If they do, they will likely be forced to impose draconian (by European standards) cuts to social programs. In addition, they will set the precedent for the other weak links. Are hurting taxpayers in Germany going to send money to Greece? In a country like Canada, there is a system for transfer payments between provinces. The EU has no such system. An IMF bailout would be a big black eye for an EU country.

I can't profess to know how this will play out. I do know that even if Greece dodges a bullet right now, there are too many holes in the EU dam that are leaking. Greece may be forced to go for some type of bailout as it would give political cover for the draconian cuts. However, it could start a run on other countries such as Spain (huge housing bubble and unemployment rate) and spill over to non EU countries such as Latvia. The EU could even decide to expel Greece if it deems that it does not have the ability to bail out member countries.

The timing is tricky (doesn't have to happen in 2010) but I don't think the Euro stays at its lofty levels. I believe that the Euro will not go away, but its luster will fade and investors will crave the security of the safe US dollar.

The next part of this bear market will involve currencies and sovereign debt concerns, I believe. And this currency crisis will involve the big guys (Euro and Yen- more on that one another day).

We are at a pivotal point for the US dollar and the Euro. A strong move that started 6 weeks ago, from 1.51 to 1.42 has now consolidated to 1.45. If the US dollar is truly in a bull market, it needs to move higher from here. Thus far, the S&P has shrugged off the higher USD, as it did for about 6 weeks back in 2008 before all hell broke loose.

My target for the Euro is $1.25 this year, but a move to $1 can not be ruled out if a 2008 crash develops this year or if we get some domino action (Greece, followed by someone else and with spillover to the usual suspects of Ukraine, Latvia, Iceland, Ireland, Hungary, etc...).

Disclosure: Position in USD, Euro, CAD

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