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:
Taken from Bruce Krasting
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