Baby Got Backs: John Taylor Sees A Race Not To One Bottom, But Two
A Race to Two Bottoms
September 23, 2010
By John R. Taylor, Jr.
Chief Investment Officer
Borrowing a quote and an idea from Winston Churchill, we would argue that the current and future EUR/USD rate is “a riddle wrapped in an enigma inside of a mystery.” Why an ‘idea’ as well as a quote? Well, Churchill used this phrase to describe the Soviet Union, a conglomeration of states managed by an opaque bureaucracy that was challenging the global capitalist system. The Eurozone is surely more benign and not quite as opaque, but their ambition is challenging the global dollar standard, a critical component of the current global capitalist system. Churchill concluded that the Soviet Union would do what was in its national interest. That made Kremlin watching easier than understanding the interplay among the many power centers of Europe. As it is clear that the Eurozone does not actually have a national interest because there are so many nations involved and that the answer to this is a conundrum, the value – and the future – of the euro is extremely hard to predict.
So far this year, the euro has lost about 9 cents against the US dollar, but it has been strong lately, rallying about 17 cents from its low in early June. The euro has shown us two faces so far: the first is the disintegrating one that dominated the first five months, and the second is the tight-fisted one that is currently in ascendance. The recent effort at rehabilitation has been fostered by the horror of the first part of the year when things unraveled very quickly as the Greek liquidity problem rapidly morphed into a question of solvency not only in Greece but in several other Eurozone members as well. The fear of a general collapse of the “Euro-project” dating from the end of World War II, and encompassing the entire career of all leading citizens, was enough to drive these leaders together. Recent successful debt auctions have shown how effective this ‘fortress’ of European policy has been. All the bond auctions, no matter how risky, have gone swimmingly. Despite the fact that the rates paid by the stricken debtor countries will force them into defaults in the next five years or less, the European financial press has been mum. Realistic or probing analyses are branded as “evil.” Unfortunately for the citizens of Europe these high rate loans are driving the EUR/USD back up. Not only will this cost the deficit countries dearly as deflation takes hold and local businesses are hurt because of cheaper imports, but the German growth engine will sputter out as it loses its export markets. This strategy is guaranteed to drive Europe into an even deeper recession in the next six months (but you won’t read this in Europe). Living standards will drop sharply in the deficit countries as they fail to meet the targets set for them by the EU, ECB, and IMF. Latvia and Ireland have shown us the horrors that lie ahead. Although the EUR/USD should rise until the economy cracks, most likely the investing world will anticipate the next crisis beforehand. A strong euro now assures us of a very weak euro later.
The US is also following an aggressive strategy, but the Americans are pushing rates down, not the economy. By emphasizing money creation through Quantitative Easing (QE), the Fed has weakened the dollar while hopefully increasing the liquidity available to the real economy. Although the process of QE might have little impact on credit growth, the weaker dollar will help stimulate the domestic economy while holding deflation at bay. If the Japanese experience is illustrative, the recession will hit the US anyway and the bank balance sheets will shrink as well. When the next recession is in full bloom by the start of next year, at the very latest, the dollar will rally as the shortage of dollars impacts global business. With the Eurozone showing severe strains next year and the dollar in short supply, the EUR/USD will be on its heels again. Only with a much weaker euro will the Eurozone authorities be acting in what most would perceive as their national interest.