All the news coming out of Europe has made for an interesting week in the markets, particularly the currency markets. The Euro has continued to plunge against the Dollar and other currencies on concerns ranging from doubts about whether the bailout of Greece will work to speculation about the future viability of the Euro. As I wrote in February, while I believe the Dollar is continuing to climb into overvalued territory, volatility and/or upward pressure will likely continue until a) the focal point of currency crises shifts to the US, or b) the crisis is resolved in a manner about which the market is confident. Neither of these has happened. As the situation plays out, I view the skeptics who doubt the Euro’s viability as misguided. A breakup of the Euro, particularly a disorganized piece-by-piece dismantling, is counterproductive and would only harm the EU as a whole. Second, the Euro’s plunge against other world currencies could trigger currency crises in other heavily indebted countries outside the Eurozone, such as Japan.
The volatile action of the Euro, accelerating during the past two weeks, is symptomatic of trading action that is less fundamentally driven than it is by news and gut instinct. As I write this, markets are being battered by Germany’s announcement that it will ban naked short-selling of shares of its top financial institutions and also of its bonds. Similar measures were put into place in the US during the fall of 2008 by the SEC in an attempt to bolster the battered shares of financial services companies. With these measures coming from a country that is looked upon as arguably the most fiscally sound in the entire EU, the ramifications have shaken the market. As a result, on Tuesday night the Dollar Index shot over 87, but retraced sharply back during the past few days. Such action also suggests large, concentrated short positions in the Euro by large trading desks all the way to small hedge funds. The sharp reversal could be indicative of a one-sided market that is ripe for a correction.
That said, the Euro is looking more oversold right now than at any point since 2007, and the Dollar is consequently looking more overbought than at any point within that time frame. Some commentators have suggested this action indicates that the market is beginning to price in the possibility of a Euro breakup and/or demise, or a correction to a permanently lower exchange rate with the dollar (refer to Charts 1 and 2). Both measures are in extreme territory, and the sustainability is questionable. However, the volatility and resultant irrationality will no doubt continue as long as such crises keep popping up.
Chart 1 – Euro Index May 2007 - Present
Chart 2 – US Dollar Index May 2007 - Present
Another story affecting the market has been the emerging speculation that Greece could be forced out of the European Union. I have serious doubts about this possibility. First, there is no established process in the EU’s protocol for the removal of a member nation. Moreover, any attempt to do so would be seriously disruptive, not to mention counterproductive. At a time when Rome is burning, so to speak, more disruption is the last thing that Europe needs. As such, I would interpret such speculation for what it is: mere speculation. Second, taking apart the European Monetary Union will inevitably be more difficult than putting it together. Marc Chandler, global head of currency strategy at Brown Brothers Harriman, stated this week that, “As there is no mechanism for this, we are dubious about the veracity. There is unlikely to be much of a consensus for this move.” The latter part of the statement touches on the bigger, real problem of the European situation. The problem is not confined to Greece, and expelling financially rogue members from the EU is not a long-term solution to the problem.
The real issue of a Greek ouster would be the implications for the rest of the little PIIGS. Portugal, Italy, Ireland, and Spain should be shaking at the possibility of a Greek ouster from the monetary union, as such would set a precedent for the same to happen to them. Therefore, there should be serious doubts that eliminating Greece would be conducive to the long-term viability of either Greece or the EU. If forced to exit, Greece will simply devalue its new currency, immediately resulting in inflation. In that case, there has been talk of reintroducing the drachma (Greece’s pre-Euro currency). This would entail a currency reintroduction with the specific intent to devalue. Greece would immediately see higher interest rates and thus a steeper wall to climb out of the current recession.
It is counterproductive from the EU’s perspective as well, since, as mentioned, getting rid of Greece would not put its problems behind it but merely shift the focus to the other, fiscally weaker members. The fundamental problem that enabled the PIIGS to dig these massive fiscal holes is that the Eurozone policymakers did not prepare a comprehensive fiscal overlay to support and enforce deficit/debt standards within what became a low interest rate monetary union; unfortunately, this union included some members who clearly did not deserve such low rates. The long-term goal of European policymakers is, obviously, maintaining the union. A mere decade into its existence, removal of any members would further undermine what is already being referred to by some as a “failed experiment.” Many commentators have mentioned that a swift breakup of the Euro would enable the indebted nations to devalue, inflate, and get on with their lives, while removing the burden from the more fiscally sound states. If this was viewed as the best solution, Greece would be close to or out the door already. But it is not. Since monetary union is the long-term goal, front and center on the solution-creating agenda should be the future enforcement of fiscal standards. While a mechanism for removal of fiscal outliers may not come to pass, at the very least rigid enforcement of fiscal standards will.
Having observed the various ways that financial contagion and systemic risk have manifested in the past few years, surmising potential effects of the events in Europe is prudent. Taking a look at the global macro picture, the next currency domino to fall could be Japan. The reasons stem from the potential effects on trade and the export-heavy Japanese economy. More importantly, the reason lies in the exporters that Japan directly competes against, Germany and the United States. One commentator pointed out this week that “exports from [Japan and Germany] are in direct competition on many aspects. In terms of products, both are strong in auto and precision equipment. In terms of export countries, both heavily rely on the US and China.” More importantly, Japan finds its currency rising against the Euro, and it comes at a time when Japan’s two largest export destinations, the US and China, are still mired with stagnant economic growth and/or the prospect of a double-dip recession. Indeed, the EUR/JPY exchange rate has fallen more than 35% since 2008 (refer to Chart 3). Germany’s largest export destinations have always been its neighbors in continental Europe. With the belt-tightening austerity measures in Greece and similar burdens likely to be placed by upon the other little PIIGS, Germany may need to look elsewhere to push its export sector, and its economic recovery, forward. As such, a lower Euro is a welcome prospect to the Germans. Therefore, I would look closely at the possibility of Germany and Japan seeing increased competition with each other, and the possibility of continued malaise in the Japanese export sector triggering a currency crisis.
Chart 3 – Euro/Yen Exchange May 2007 – Present
Not surprisingly, China has recently surpassed the US as the top export destination for Japanese goods. Although China’s long-term growth fundamentals are solid, in the short term many investors are wary, and rightfully so, about China’s need to put a damper on inflation and an overheating real estate market. With a second leg of the recession looking certain for Europe and still very possible in the US, Japan’s exports will likely be under pressure for some time. Therefore, the last thing Japan needs is increased competition with other exporters.
Obviously, the main reason why I focus on Japan is their 200% debt/GDP ratio. This is nothing new, having built up gradually over the past 20 years. However, one of the main reasons that a major currency crisis has not come to pass is because of Japan’s culture, “collectivist,” as one commentator aptly put it. In other words, Japanese citizens are more willing than one would think to pour their life savings into helping the government if it was in trouble. Combine that with a high domestic savings rate, and the result is that Japanese citizens and corporations own well over 80% of Japanese Government Bonds (JGB’s). The collectivist bent of the population and domestic savings rate are not going away. At the same time, a population that is ready and willing to help can only delay a crisis to an extent. Without resiliency in the export sector, the task will become much more difficult.
In conclusion, the situation in Europe will provide for an interesting narrative in the weeks and months to come. The possibility of a Euro breakup, while unlikely, has been exposed and is clearly being taken seriously by the market. Yet, if the focus of the crisis were to shift to elsewhere, perhaps to Japan, the Euro might suddenly rebound. Right now, one might wonder why the Euro was ever priced at 1.50 US Dollars given what is now known, but this and the current movements should not be taken as a sign the US Dollar is any safer in the long term. Fiat currencies around the world will face a serious test of their viability over the next two decades. The pace at which these tests will occur is yet to be determined, but will no doubt be heavily influenced by decisions made now and in the next few years.
Respectfully Yours,
Matthew R. Green
May 21, 2010
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