For the third day in a row, the euro has bounced against the dollar, leading many traders to wonder whether the single currency has finally hit a bottom. When the EU/IMF rescue package was first revealed, euro traders ignored the bold attempt by policymakers to stabilize the markets because of the abundance of unanswered questions (listed below). About half of the questions have now been answered, albeit with minimal details which is why we have to respect the recovery in the euro. The ECB has released the initial details on the scope of their bond purchases and their sterilization plans while the German Parliament has finally approved their portion of the EU rescue plan. Greece still needs to decide whether they will accept the terms but for the most part, the short term questions have been answered. The main reason why there was Euro breakup speculation earlier this month was because France threatened to leave the euro if Germany did not approve the plan and now they have.
Yet the long term concerns about growth remain and that is why global equities have found little relief. This morning's Eurozone economic reports provide the first evidence that the turmoil in the markets is starting to take its toll on German businesses. As the austerity plans are implemented, the impact on growth will become even more significant. Yes, the weak euro is stimulative, but it may not be enough to offset weaker domestic demand. In the short term, the key will be equities. If the 10,000 level in the Dow holds, it may stabilize risk. If it doesn’t and we see another 200 point decline, the EUR/USD may find itself back below 1.25
Initial Questions from EU/IMF plan:
1. What will be the exact mechanics behind the Special Purpose Vehicle that will provide the EU440bn that is guaranteed by member states? What are the rules and terms
2. Will the SPV need to be approved by individual nations / Parliaments and if so, when will this happen?
3. Will Greece accept these terms? Will they amend it?
4. Can all countries afford to contribute to the plan and will the countries seeking aid be able to handle the tough conditions that may accompany the loans ?
5. What is the size and scope of the ECB's bond purchases?
EUR/USD Rally Reduces Chance of ECB Intervention
Furthermore, the ECB is not likely behind the recent rally in the euro, which means that the short covering has fueled the recent move. The recovery in the EUR/USD will reduce pressure on the ECB to intervene in the euro because someone else has done their job for them. Neither central bank has admitted to intervention which is characteristic of the SNB but not the ECB. Furthermore, if the ECB did not intervene in its currency, why would they admit it? Any admission would lead to further weakness in the euro, more volatility in the foreign exchange market and additional speculation about when the ECB would finally intervene. By remaining quiet, they leave the market guessing that they may have intervened, which for the time being has created a bottom in the EUR/USD.If the ECB intervened, they would be far more vocal because the point is to shock the market and get traders to stop selling euros. The SNB on the other hand has been silently aggressive for most of the year.
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 these programs were first being implemented and 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.
The biggest story in the financial market continues to be the weakness of the euro. In the past 24 hours, the currency has blown through its 1.25 and 1.24 support levels and is now trading just a hair above its lowest level against the U.S. dollar since October 2008, the same month that Lehman Brothers’ collapsed. The extremeness of the recent price action suggests that investors are just as nervous about the current market environment as they were about the economic outlook back in late 2008. However the big difference is that back then, the problems stemmed from the U.S. and today, the problems are in Europe. This has encouraged investors to buy dollars for both save haven and relative growth prospects. The latest breakdown in the EUR/USD was triggered by concerns that the Eurozone could breakup as a result of the sovereign debt crisis. In turn, the weakness in the EUR/USD has raised questions about whether the currency pair is destined for parity, where one euro is worth one U.S. dollar. Is Euro Destined for Parity? The last time the EUR/USD traded at parity was in 2002 and at that time it was rising from lower levels. If the currency pair broke its October low of 1.2329, which is not very far from current levels, it would take the EUR/USD to its lowest since April 2006. Given the rapid response of global policymakers to the volatility in the financial markets on Thursday, there is only a very small chance that the ECB would allow the euro to reach parity without attempting to stop its fall. Although a weak currency helps to boost growth, there comes a point when it becomes a greater risk to inflation and a threat to the growth in other countries. The only possible scenario under which the EUR/USD could reach that point would be if the euro was at the brink of dissolution. Part of the reason why the euro fell so significantly today was because of French President Sarkozy’s threat to leave the Eurozone if other members (ahem, Germany) does not approve the EU/IMF rescue plan. Germany is dragging their feet in getting Parliamentary approval which is one of the unanswered questions that we outlined when the rescue package was first unveiled. Until this and other issues are addressed, investors will be weary of holding euros. However given that Angela Merkel admitted today that things would be a lot worse if the EU and euro did not exist, there is a good chance that Germany could approval the package soon. There are too many benefits to having the euro and too many consequences or complications with returning to individual currencies that the euro is not going anywhere anytime soon. It is much more likely that other countries within the Eurozone will vote to force out their weakest links than to dissolve the monetary union entirely. Although we believe that the euro is not destined for parity, it should see more losses with a possible test of 1.20. Euro: Destined to be a Funding Currency What the euro is destined to be for at least the next year is a funding currency. Concerns about the impact of the austerity measures on growth are serious and the European Central Bank is fully aware of this. Therefore we expect the ECB to lean towards easier monetary policy for next few months with a possible return to quantitative easing. Unlimited repo tenders and purchases of government bonds are all actions of a dovish central bank. The only hope for the euro would be a positive reception to the final approval and implementation of the mammoth rescue package announced at the beginning of the week. The G7 could also intervene in the foreign exchange market and buy euros which would at minimum trigger a relief rally in the EUR/USD, shaking out shorts. The perfect time for central banks to intervene to buy euros is when the market is extremely short as short covering would compound the rally. According to the latest IMM data, euro short positions have once again climbed to a new high. If Parliamentary approval continues to be delayed and the ECB decides not to stem the currency’s slide, then another downgrade of Greece (which is very possible) could take the EUR/USD down to 1.20 and beyond. Next week’s economic reports from the Euroozne will continue to take a back seat to the Sovereign Debt Crisis. The German ZEW survey, IFO report, PMI and inflation numbers are scheduled for release.
USD: BENEFICIARY OF SAFE HAVEN AND RELATIVE GROWTH FLOWS
The U.S. dollar appreciated against every major currency except for the Japanese Yen as better than expected economic data makes the dollar more attractive from a relative growth and safe haven perspective. Based upon the latest consumer spending, industrial production and confidence reports, the U.S. economy is chugging along. The improvement in labor market has helped to turn the entire economy around, albeit at a glacial pace. Although the exposure of U.S. financial institutions to German banks and in turn, the exposure of German banks to Greek banks makes America exposed to Europe’s sovereign debt crisis, for the time being, investors are focused on the source and not the ripples. Even if the U.S. economy is affected, the Federal Reserve could still normalize monetary policy before the ECB. According to the retail sales report, US consumer spending grew at a slower pace in April but with the upward revision in March and the seventh straight monthly gain in spending, the drag on the dollar was minimal. Both overall retail sales and sales excluding autos and gas rose 0.4 percent, beating expectations. However the big surprise was in the March figures which were revised significantly higher. Instead of rising 1.6 percent the prior month, spending actually rose 2.1 percent. Retail sales ex autos were revised up from 0.6 to 1.2 percent. Demand was particularly strong for building materials, health care and personal care products but spending at department stores decreased due to the early Easter Holiday. Consumer spending growth may have slowed but it is growing and distortions can be mostly attributed to the holiday. April was a strong month for retailers, but March was exceptionally strong. Unfortunately, the pickup in U.S. consumer spending failed to stabilize risk and offset the jitteriness caused by the uncertainty in Europe. Meanwhile industrial production rose by 0.8 percent and capacity utilization increased from 73.1 to 73.7 percent which should not be all that surprising considering that manufacturing grew at its fastest pace since 2004. According to the University of Michigan survey, consumer sentiment improved in May but not by as much as the market had anticipated which added salt to the wound and exacerbated the weakness even though normally, the improvement would be enough to stabilize risk. In the week ahead, inflation, housing and manufacturing reports are due for release. The Federal Reserve will also publish the minutes from their most recent monetary policy meeting while the Treasury will release the latest figures on foreign demand for U.S. dollars.
GBP: NEW GOVERNMENT TRIES TO GAIN YOUR RESPECT
The third straight decline in the pound brought the currency dangerously close to a new yearly low against the greenback. Still, today’s weakness capped the third straight week of pound declines. Sterling was pressured today by a sharp drop in U.K. stocks, which saw the benchmark index lower by the most in about six months. Clearly, traders are finding that the U.K. has much higher exposure to the European debt crisis than many other industrialized nations, especially due to their geographic proximity. Nevertheless, traders should be comforted somewhat by the fact that the new coalition government has wasted no time in proposing sweeping deficit reduction plans. Yesterday night marked the inauguration meeting of the new government, which concluded with an overwhelming seal of so far so good. Officials announced that their first plan of action would be to cut compensation of U.K. ministers by 5% as well as impose a strict freeze on salaries for the next five years. Even though things have been moving smoothly lately, it will take time for the new government to earn the market’s confidence. Separately, David Blanchflower, a former Bank of England policy maker, said that he would have like to see the bank boost its assets purchases “by a lot” at their last meeting, responding to growing expectations that the bank will have to ease further as the government tightens fiscal restraints. Blanchflower has traditionally been more dovish than his peers. Next week’s main event risks are Tuesday’s Consumer Price Index, Wednesday’s release of the BoE’s Minutes, and Thursday’s Retail Sales.
NZD: RETAIL SALES THREATEN CHANCES OF A JUNE RATE HIKE
Commodity currencies sold off as uncertainties in Europe overwhelm any trace of risk tolerance left in markets. USD/CAD shot lower by the most in a week, driven primarily by a plunge in oil prices that saw crude fall more than 3.5%. New Zealand’s Retail Sales were released today and were a broad disappointment, coming in at only half of consensus expectations. Retail Sales rose at the slowest pace in a year while core sales fell for the first time in four months at a critical in juncture that is sure to have consequences on the probability of a June rate hike by the Reserve Bank of New Zealand. Today’s clear sign of weakness presents a strong argument that the bank may have to wait longer than expected so not to stifle growth in a still hobbled economy. The sales report showed that performance improved in only slightly more than half of its underlying components, driven by vehicle sales and dragged by food and drink sales. New Zealand has the Performance of Services Index in store for Sunday night and Producer Prices for Monday. In Canada, Motor Vehicle Sales dropped sharply by 4.2%, while Manufacturing Shipments rose for 0.1% to 1.2%. Canada has its Leading Indicators and Consumer Price index due late next week. Australia, on the other hand, is set to release the RBA’s Minutes on Tuesday, Westpac Consumer Confidence on Wednesday, and Inflation Expectations on Thursday.
JPY: ALREADY SEEING EFFECTS OF STRONGER YEN
The Japanese yen strengthened against the dollar for the second straight day as traders, frightened by grim signs coming from Europe, chose to stock away their money in the safety of the yen. The story was very much the same across all actively traded currencies, with the commodity dollars noticing a particularly sharp loss against the currency. As expected, along with the yen’s gains today came a more than 20% rise in the Volatility Index, which explains the extent to which market worries have risen. Japan’s Nikkei 225 index was not insulated from today’s events, and fell 1.5%. Aside from global concerns, it has been primarily weak earnings forecasts that have been weighing on the index, an event many see as a direct result of the strengthening of the yen, which poses a significant threat to exporter profits. No economic data was released in Japan for today, but we are expecting more for next week. To start things off, we have the Tertiary Industry Index on Monday, to be followed by Consumer Confidence on Tuesday, preliminary GDP on Wednesday, and the BoJ’s rate decision on Thursday. It will be interesting to see whether the BoJ has changed their tone, especially after the two consecutive liquidity injections that took place last week.
Unanswered Questions 1. What will be the exact mechanics behind the Special Purpose Vehicle that will provide the EU440bn that is guaranteed by member states? What are the rules and terms 2. Will the SPV need to be approved by individual nations / Parliaments and if so, when will this happen? 3. Will Greece accept these terms? Will they amend it? 4. Can all countries afford to contribute to the plan and will the countries seeking aid be able to handle the tough conditions that may accompany the loans ? 5. The IMF supposedly has $268 billion left, where are they getting the rest of the money? 6. What is the size and scope of the ECB's bond purchases? Although European policymakers and the G7 are committed to defending the euro, with many political hurdles ahead, the details need to be ironed out and it may be a while before it is finally implemented. At the same time, the ECB's decision to buy government bonds has also undermined the central bank's credibility. Last Thursday, ECB President Trichet said buying government bonds was not even discussed and 2 trading days later, the announcement was made. It is hard to believe that the central bank was not pressured into market intervention, particularly since the decision was not unanimous. Investors are rightfully concerned that the central bank has not figured the details out and are simply providing additional firepower to the EU/IMF's announcement. Ultimately, the fact that the ECB is implementing a light version of quantitative easing will limit the positive impact of the rescue plan. The markets may not find support until the plan is finally implemented.
EUR/USD: Currency in Play for Next 24 Hours
EUR/USD will be the currency pair in play for Monday. The Euro-zone will release New Car Registrations at 2:00 am ET or 6:00 GMT. The U.S. will be releasing the Empire State Manufacturing Survey at 8:30 am ET or 12:30 GMT, followed by Net Long-Term TIC Flows a half-hour later. For five straight weeks, the euro has fallen, keeping EUR/USD well within the Bollinger band sell zone on both a daily and weekly basis. A major support is not too far away and lies at the October 2008 low of 1.2328. If this level were to be broken, we are talking about a new four-year low in EUR/USD. On the other hand, resistance can be found at the 10-day moving average, which lies at 1.2733, a level close to the lower one-standard deviation Bollinger band.
As the Euro declines, which it no doubt will continue to do over time as the ECB printing presses go into Warp Speed, the main beneficiaries will be the Western economies. And while it’s also likely to slow the Chinese economy for now, in the longer term euro depreciation will help to serve a needed purpose there.
First, because oil is bought and sold in dollars, you might think that euro depreciation relative to the greenback will cause the cost of oil to increase in Europe. The opposite, however, appears to be true right now.
The cost of a barrel of oil was 64.54 euros at the start of trading on May 3 when the euro opened on $1.3354. But with the euro recently at $1.2638 and the price of light sweet crude falling to $75.88/bbl, oil has fallen to 60.04 euros (a 6.97% decline in just over a week).
Second, because the yuan is pegged to the dollar, it’s undergone (and will continue to undergo) an appreciation relative to the euro. This of course will make European exports more completive in China and will go a long way towards correcting the huge trade imbalances which now exist. It should also help cool Chinese inflation and its overheated economy, including its property bubble, first because exports to Europe (China’s largest export market) will slow as they become more expensive and second by making imported commodities cheaper (because they will decline in price as the dollar appreciates).
Chinese stock markets are likely to continue their decline in the medium term as the economy slows. Actually, we’ve already seen this happen; the Shang Hai composite is negative for the year and has basically fallen into a bear market. However, as Marc Faber has so astutely pointed out, Chinese stocks might actually benefit as capital is diverted from real estate investments.
As far as the U.S. is concerned, falling oil prices will greatly benefit consumer spending especially with the job market remaining extremely weak. True, the effect on exports is likely to be negative, but consumption is a much bigger contributor to overall GDP.
Significantly, falling oil prices will keep the Fed on hold longer (is there such a thing as longer than “forever”?) as inflation becomes even less of a threat than it already is. Indeed, core CPI increased by just 1.3% in the year to March and in the first 3 months of 2010, increased at a frighteningly low 0.1% annualized pace.
The longer the Fed stays on hold, the more that large commercial banks like JP Morgan Chase and Goldman Sachs, which racked up perfect quarters in their trading businesses between January and March, will continue to make easy profits. How can they lose when they can borrow at 0.25% and lend to the U.S. government at multiples higher? Even Marco Hague of TheLFB would have trouble messing up that trade (well, maybe not)!
Goldman reported that net revenue was $25 million or higher on each of the days it traded over the period, and said it made more than $100 million on 35 of those days, or more than half the time.
How can Goldman and the other banks manage this trick? The simplified version goes like this: First, they can borrow at 0.25%, which allows them to leverage up. The borrowed money is then used to buy Treasuries from the Fed at some discount (possibly something like3% to 4%) which is then sold at Par plus commission, thereby earning a spread (the same as our forex dealers make). When the time comes to buy the Treasury back, the bank offloads it to the Fed while again earning at least a commission on the repurchase (if not another spread).
Of course, they can also borrow and hold Treasuries on their own book, a trade that’s greatly helped by the steep yield curve which allows them borrow low and lend high.
Gold is likely to continue being the main beneficiary of Europe’s scheme to print. It reached an all-time high in nominal terms of $1234.15 on May 11 and then tested support at the former resistance on $1226.37, made on Dec. 3, 2009, the following day.
EU officials meeting in Brussels over the weekend agreed to a massive rescue package totaling near 1 trillion dollars that would guarantee sovereign debt within the Eurozone. The deal includes an array of measures including $560 billion in new loans, $76 Billion under an existing facility as well as additional credit for the IMF of up to $321 Billion.
To further buttress the moves of the fiscal authorities, monetary officials from the Fed, the ECB, the BOE, the BOC and the SNB all agreed to reopen currency swap lines in order to ease liquidity in the money market and the interbank markets.
The concerted effort by the EU finance ministers and G-7 monetary authorities was a clear sign to the markets that the union stood ready to rebuff the speculative runs at the credit of Southern European economies that have threatened the financial stability of the Eurozone and the prospects of the euro itself.
However many analysts continued to express skepticism as to whether the deal which creates a special purpose vehicle with a three year duration and which will be dependent on “national constitutional arrangements” will be robust enough to withstand the possible stresses to come. Several key Eurozone members are facing massive rollover risk in the credit markets with Italy having 600 Billion euros come due over the next two years while Spain will have to refinance 220 Billion euros and Portugal will need to raise more than 40 billion euros over the same time frame.
At the very minimum today’s action stabilized the beleaguered currency for the time being with EUR/USD recovering to an early morning high of 1.2980. The short euro trade has become incredibly crowded over the past week and today’s price action punished the late euro shorts as they scrambled for cover in the wake of the EU announcement. However, 1.3000 remains a key resistance level for the pair and so far the unit has been unable to mount a rally through that figure.
More importantly today’s opening created a gap and given the recent price history in the currency market that gap will likely be filled over the next several days. The key test of euro strength may come once that price action occurs. If the euro can hold the panic lows set late last week, the unit could then mount a more sustainable recovery rally as confidence slowly returns to the market. Long term however, the direction of the euro remains very much an open question given the highly dilutive measures taken today.
Bureaucracy: Greece's bureaucracy is famous in the whole of Europe ! To open a cafe or pub there are 25 processes to go through !! This is a country of rules and regulations. Bloated civil service: There are 1.05 million civil servants (excluding police and armed forces) . The population of Greece is only 10 million !! More than 10% are govt servants !! Salary increases every year and benefit for civil servants in Greece is one of the best in Europe !! More and more money is needed to upkeep this bloated civil servants . The retirement age is 62 yrs old. Corruption: Greece is the most corrupted nation in the Eurozone. Citizens pay "under table " money to: # admit into a public hospital # pass a driving licence # to enter public service # renovate your business premises or your home # avoid income tax Every govt project is awarded to political cronies and at hugely inflated prices ! Transparency International compared the prices of the construction costs of stadiums built for the Athens Olympics recently with similar structures in China --500% more expensive than the Chinese , compared to Los Angeles and Sydney -- 50 % more expensive !!! All these with tax payers money ! and borrowings !!! Tax evasion: Officially 80% of its citizens are supposed to pay tax but only 37% are doing so. Big businessmen and corporations have refined tax evasion to a fine art ( or have the tax men taken some coffee money ? ) No transparency in governance: The politicians and bureaucrats falsified economic data and painted a rosy and manageable picture while the economy was rotting away . Unabated borrowings: Meanwhile, the politicians and bureaucrats continue to issue govt bonds to keep afloat, series after series. They were trying to cover up the financial mess they have created creating one big hole to cover up the previous !! Lacking political will power to reform: To keep hold on to political power, politicians are prepared to lie, commit economic and political fraud. If reforms were taken some five years ago , the country need not go bankrupt and its citizens need not suffer so much. Political expediency and greed to political power over-rides everything and hence Greece is now a bankrupt country. Luckily, it is part of the European Union and its currency is EUROs, otherwise Greeks will have to eat grass to survive !! Laid back attitude: Tourism is THE ONLY industry in Greece and over the years the Greeks have had an easy time. Many flocked to see the historical sites. enjoy summer vacation on the islands. But they forgot that not many tourists will return after visiting the sites --there are so many other tourists attractions in the world, maybe more exotic and perhaps cheaper !! So once tourism vanes and coupled with higher costs of living --the Greeks could not and refused to adapt and transform --still partying and having a nice time -- maybe the Greek Gods will bless them !!! Greece have no natural resources, no electronics industry , no R & D --no anything !! They were so laid back --cannot see what is coming and crashing down on them. Even now, the civil servants refused to take a pay cut -- the world owes them a living !!
The New Your Times published a very interesting chart the other day which outlines how deeply in debt the PIIGS (Portugal, Italy, Ireland, Greece and Spain) are: $3.889 trillion or 4.958 trillion euros at Friday's exchange rate. Of that amount, $2.053 trillion or 2.617 trillion euros, is owed to Germany, France and Britain (or presumably, their commercial banks).
Meanwhile, the absurdity of the Greek "rescue" package will only serve to put the nation further into debt both in absolute terms and in percentage terms of its GDP. As of 2009, Greece's GDP was about $345 billion, which means its debt-to-GDP percentage was 68.4%. But with $136 billion of new debt (the EU-IMF rescue package) and with Greek GDP estimated to fall about 4% in 2010, the percentage of debt-to-GDP rises to over 112%.
In other words what we have here is round 2 of the debt crisis, which is defined as "which banks are exposed and by how much." Round 1, as you're probably aware of, occurred in September 2008 after Lehman Bros. was allowed to collapse. At that time, as now, no one knew exactly which banks were exposed or by how much (although it was generally known that the exposure was huge). As a result of the uncertainty, inter-bank lending rates (LIBOR) soared as banks refused to lend to each other, which naturally caused financial markets to freeze.
We're already seeing the beginnings of this same scenario happen right now. On Friday, 3 month LIBOR (the cost of borrowing dollars for 3 months) climbed 5.5 basis points to 0.428%, the highest level since Aug. 17, 2009 and the biggest increase since Jan. 16, 2009. It also was the 13th straight gain in this "fear gauge."
The spread between three-month Libor and the overnight indexed swap rate rose more than 6 basis points to 18.5 basis points, the most since Aug. 26 2009. The measure at one point ballooned to 364 basis points, or 3.64 percentage points, after the Lehman debacle.
According to Simon Johnson, former chief economist at the IMF and co-author of the new book 13 Bankers, the joint EU-IMF program has only a “small chance of preventing an eventual Greek bankruptcy.”
During the negotiations which occurred prior to the announcement of the Greek plan, The IMF floated an alternative scenario with a debt restructuring, but this was rejected by both the European Union and the Greek authorities. This is not a surprise; leading European policy makers are completely unprepared for broader problems that would follow a Greek “restructuring,” because markets would immediately mark down the debt (i.e. increase the yields) for Portugal, Spain, Ireland and even Italy.
The fear and panic in the face of this would be unparalleled: When the Greeks pay only 50% on the face value of their debt, what should investors expect from the Portuguese and Spanish? It all becomes arbitrary, including which countries are dragged down. Adding to the problems are that European structures are completely unsuited to this kind of tough decision-making under pressure.
So, where do you go as a trader? Certainly, in the face of what’s happening you want to be out of anything that looks risky, which means stocks and commodities. The dollar is likely to continue gaining in this situation because there’s no other paper currency which can serve as an alternative. But there is one other “currency” however: Gold.
In “normal” times, gold trends downward as the dollar gains and it rises when the dollar falls, which is what happened once the dollar began depreciating as stocks rose from Mar. 09 2009. But when panic sets in, as it did after Lehman collapsed on Sept. 15, 2008, gold appreciates along with the dollar. For example, from that day until stocks begin rising, gold went from $779 to $929 while EUR/USD went from 1.4242 to 1.2889.
Gold and the euro peaked in early December as traders first began speculating on European problems. But once the market started to better appreciate the full extent of the European debt crisis in early February, gold rose from a low of $1044 to reach $1207 even as EUR/USD fell from 1.3677 to Friday’s close on 1.2750.
I would look for this trend to continue, because what’s going to happen is either one of two things: Debt restructuring or the far more likely debt monetization by the ECB, which means that Europe’s Central bank will be printing a lot more euros in order to buy the debt of the PIIGS.
I made the following predictions back in December. Things have evolved in ways such that I am close to being completely right or completely wrong on both of them.
-The Federal Reserve will become active in the foreign exchange markets. At different times of the year they will both buy and sell dollars. Their objective will be stability. These efforts will be referred to as “smoothing operations”.
-There will be no breakup of the Euro. Greece will not pull out. The strong members will provide some relief for the weak. But the problems will not go away and the possibility of some form of two-tiered Euro will be a matter of open discussion. It is in this context that the Fed’s FX intervention takes place.
In my opinion the decline of the Euro in 2010 has be orderly, up to the last week. Two "big figures" on any given day is part of the adjustment process that is necessary due to the changing fundamentals. That is not disorderly. But we have lost five big figures in a week. That is a big adjustment, but is still not the Central Banker's definition of a market that would necessitate coordinated intervention. But it is getting close. A few more days at the current pace would likely get us to the point where some action may be required.
The problem is that the Euro/$ is the "go to" trade that reacts to every bit of bad news that is coming out of the EU. I am not sure if the Euro is falling because Spanish bonds are in the crapper or if Spanish bonds are getting hit because the Euro is so weak. If the deep thinkers at the EU central bank are in the later camp then they must be itching to react. Everything they have built for the past 20 years is coming unglued. They are unlikely to go down easy.
I dismiss the news/rumor/importance of the BIS being in the market. If something is going to come it will arrive with a bang and it will not be subject to any guesses. There will be clear statements by the ECB that they have, “Acted decisively to stabilize markets”. They will sell 10-30 billion dollars into the market over a few days. That is not that big an amount in the FX markets, but it will have the effect of re-establishing the notion of “two way risk”. It has been far too easy to make money shorting the Euro. They need to change that risk/reward equation.
This possible action could take a number of forms. Should it happen it would look like one of the following:
A) The EU Central Bank draws down swap lines at the Fed and sells dollars for its own account. This is the “Go it alone” approach. It will not work. It will look like a weak effort that does not have the support of the other central banks. It will fail in short order.
B) The ECB and the Swiss National Bank would intervene jointly. The Swiss would buy Euros and sell the CHF. (They love to do that, but have been bashed by the market in the past). While this approach would be better than A, it would not get the job done.
C) The Bank of England joins in with the ECB and the Swiss. This would be a hell of a party, and probably would reestablish a two-way market. But I don’t think it will happen. There is too much election pressure for the BOE to get involved, unless:
D) The Fed joins the festivities. That would be decisive, and with the US cover the Brits would get in the game.
A and B will end badly, C will not happen. Only D has a chance of buying two to three months to address some of the problems. At best this means by the end of the summer we will be back at it.
It is equally possible that the global CBs will do nothing and the Euro makes a beeline to 1.10. That approach will end badly as well. My prognostications will not come true. If the Euro was to collapse, Greece would be forced out of the Euro Zone, and it would be followed in short order by a sharp decline in economic activity for 500mm people.
I made another prediction back in December. If A, B or the “Do Nothing” plan are in the future, then I think this one will come home:
