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Euro And Europe Update, And Latest Goldman Mea Culpa
From Thomas Stolper of Goldman Sachs
1. Overview
Risky assets came again under pressure overnight with a notable sell-off in Asian markets and a weak open in Europe. S&P futures have posted new lows for this correction.
There is continued focus on the continued widening in Libor-OIS spreads, now clearly the widest seen in many months, but compared to what we have seen in 2007/2008, the move is less impulsive, which is consistent with the fact that banks sit on much better liquidity buffers these days.
In currency space and similar to equities, most pro-cyclical currencies came under pressure, in particular the KRW, which was also affected by political tensions between the two Koreas.
There wasn't much on the data calendar yesterday, but quite a bit of news regarding Spain, notably that four Spanish savings banks (cajas) decided to merge to form one of the largest financial institutions in Spain. This follows on from the temporary take-over by the Bank of Spain of small CajaSur. The IMF also published a Mission Concluding Statement on Spain, which provides a broad assessment of the ongoing reforms and remaining challenges. Given Spain remains the focus of financial markets with regards to the multiple challenges facing the Euro, we use the latest new flow to put our EUR/$ forecast into context and to illustrate the factors that would trigger a re-think of our forecasts.
Today’s calendar has US consumer confidence, US house prices and UK GDP as the most notable items.
2. Brief Summary of our EUR view.
On May 14, we published our latest FX Monthly, largely focusing on why we decided to not change our EUR/$ forecasts. We expect EUR/$ to strengthen back to 1.35 and then to stay broadly unchanged in that area.
Our view boils down to the following: while there is ample evidence for a very large short EUR position in the market, closer inspection of some of the more negative claims about the Eurozone are difficult to defend. As an example we looked at the net growth impact of fiscal contraction in the Eurozone in 2010. It appears projected fiscal easing in bigger countries will likely offset the growth impact from fiscal tightening in southern Europe and Ireland.
Moreover, we noted that the focus is plainly on the Eurozone with very little focus on US fundamentals. This becomes particularly relevant when looking at external balances, which continue to be more favorable for the EUR than the USD. But even with regards to the fiscal adjustment, it appears markets are less interested in the similarly important need too tighten fiscal policy in the US.
3. Fiscal Adjustment in Comparison: Euroland and the US
The same day we published our FX Monthly, in which we pointed out that the focus is too narrowly on the fiscal outlook in the Eurozone, the IMF updated its "Fiscal Monitor" (http://www.imf.org/external/pubs/ft/fm/2010/fm1001.pdf), the single best global comparison of fiscal policy and adjustment needs we have come across. In section III of the report the authors provide evidence that rising debt levels form a medium to high starting point become a negative for growth. On average, a 10 percentage point increase in the initial debt-to-GDP ratio is associated with a slowdown in annual real per capita GDP growth of around 0.15 to 0.2 percentage points per year, according to the authors.
The report then discusses what kind of adjustments different countries have to go through to achieve certain debt targets that reduce the negative impact on growth. To quote the report again: "The adjustment is highest [...] in countries with high initial cyclically adjusted primary deficit and debt levels (Greece, Ireland, Japan, Spain, the United Kingdom, and the United States)."
This quote is interesting because the three Euroland countries in this list only account for about 16% of Eurozone GDP. In fact, adjustment needs in most EMU member countries are significantly lower than in the US. One of the reasons the US scores so badly is because of health and age related Government spending.
4. Where Could We Be Wrong?
While we have made the arguments for a while that macro fundamentals do not warrant the continued EUR/$ decline, the market has generally continued to push EUR/$ lower. Where could we be wrong? We see three possibilities.
The first is simply that the markets continue to push a view that ignores fundamental considerations for longer. With speculative positioning suggesting record shorts, perhaps the market may be overshooting in one direction (that may eventually prove to be less justified).
A second possibility is that our own view of macro fundamentals turns out to be wrong. Rapidly slowing Eurozone growth or a much better US growth profile would likely see us revise our growth and FX projections, although there is no smoking gun for this yet.
Third, the market may simply be focused on something other than the standard cyclical and balance of payments issues. And what most investors worry most about is the policy framework in Euroland and the ability to react. Even if the ultimate fiscal adjustment needs are bigger in the US, most believe the US can deliver. On the European side, policy coordination seems more unpredictable, and hence even relatively small issues like Greece (all investors know how small Greece really is) are capable of creating huge frictions. And whether this lack of coordination is due to regional elections or other factors does not really matter. If it has happened once, it can happen again.
Political frictions will almost certainly appear during the negotiations of a new framework for better Eurozone fiscal coordination. Some time ago, we called the Euro a "homeless" currency and this still seems appropriate.
FX fundamentals seem to point in one direction but politics point the other way. Investors seem to worry a lot more about the politics right now and most importantly the ability to deliver by Eurozone policymakers.
5. The Burden of Proof - News from Spain
The ability to deliver is more important in Spain than anywhere else - for the Euro and for broader risk sentiment as well. At 12% of Eurozone GDP Spain is systemically important. It is therefore helpful that the IMF has provided a timely and unbiased assessment on Spain. Yesterday's Mission Concluding Statement can be summarised in two bullet points. The necessary reforms in Spain are 1) tough but manageable and 2) good initial progress has been made.
The problem for most market participants is that "good initial progress" is just not good enough. What eventually became the EUR110bn Greek package was nothing more than "good initial progress" for months.
Spain has to demonstrate that it can deliver.
Coming back to our forecasts and, they are premised on the belief that Euroland will deliver enough evidence in the near future that fiscal sustainability can be achieved. But if evidence is still lacking by the middle of summer, concerns about long-term fiscal sustainability would become more and more difficult to refute.
The good thing is that Spain seems to be making good initial progress. The IMF highlights three areas of critical reform, labour markets, fiscal consolidation and banking sector consolidation.
On fiscal reform the IMF commends the latest package as it "significantly strengthens and front loads the envisaged adjustment and enhances credibility by taking concrete and bold measures, such as cutting public sector wages." Given the now front-loaded public sector wage cuts start in June already, fiscal data available from late July onwards should show the first signs of tangible improvements.
The IMF bluntly claims "the labour market is not working", and labour market reform is critical to spur growth. Trade unions and employers have been negotiating the reform of the labour market for some months. The government has set the end of May as a deadline for an agreement and warned that, in its absence, it will impose by decree its own reform - most probably in June. There is also the risk that social partners are too timid in reforming the wage bargaining system, which again would mean the government has to get involved.
Finally, the IMF calls the Spanish banking sector sound with robust capital and provisioning buffers. However, in some areas, notably the cajas, consolidation has been far too slow and needs to accelerate as demanded by the IMF in the Mission Concluding Statement ten days ago. Since then Spain seems to be delivering on that front as well. CajaSur was taken over by the Fund for Orderly Bank Restructuring (FROB) and, according to newspaper reports, will soon get auctioned to the best bidder after a capital injection. Of course the FROB will compete with the government in bond markets and this could be a hurdle in itself. Still, initial progress is now being made as also highlighted by last night’s announcement of the merger of four cajas. Many more have to follow.
All told, we are cautiously optimistic that these trends continue and by July/August Spain should have delivered in the key policy areas. This should include clearly reduced government spending, substantially improved labour market flexibility and many more cases of FROB-led consolidation among the cajas. Failure to deliver in these policy areas would imply that a notable rebound in EUR/$ would become quite unlikely - something we would need to reflect in our forecasts. And this is not just about Spain. Portugal, Greece and most other Eurozone countries also need to provide proof that reforms are progressing, and that policy coordination has improved.
Finally, as explained above, we continue to look out for changing macro factors that would make new forecasts necessary, but that’s our normal modus operandi anyway.
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oh yeah, at sometime in the distant future, it may come back to 1.35 and above, pure GS bullshit.
word to that, in the meantime we'll have to go through a series of new lows. Accompanied by a new series of buy recommendations... speaking of which, I wonder if GS is still recommending 'suckers.. customers buy on the dips'?
Their forex client advice is losing them business.
Moin from Germany,
GS ( or better their remaining clients.... ) also got kicked out of their long DAX 5950 position at 5650.....
All this within less than 10 trading days.....
What crap. They are stuck with a 1.35 forecast and don't have the balls to change direction. All economists are slow to adjust forecasts. Prop traders are not. My bet is that GS is max short Euros vs the crosses.
Not unusual for a wall street firm to be 'talking' one side of the market while trading the other side. This one looks pretty silly though...
As a dog returns to his vomit, so to a fool to his folly.
-Proverbs 26:11
Or as they say in Arkansas; "When it rains it pours, son."
Q: Who be followin' these recommendations anymore?
A: The Foundation for the Debasement of the Gullible and Mentally Impaired.
So, the good ol' euro at a buck thirty-five, eh?
And they ask the question, "4. Where Could We Be Wrong?"
Um, let's see. Maybe they could be wrong.....
In the number.
Just a wild guess, but maybe that's where they could be wrong.
Trying to generate some more bid size for the squid to sell into.....
DEBT EURO I:
http://williambanzai7.blogspot.com/2010/05/dead-euro.html
$1.35 for Goldman Clients=$1.10 for Goldman principal traders...
In USSA, everyone have job!
Some even paid!
1.35? Where do they get off with that prediction? European banks are largely insolvent and are probably in worse shape than we are. ECB is willing to take on more and more junk debt and comitting 1 trillion Euros (while NOT printing). GS is full of crap.
Europe definitely in a more complex predicament.
They have to save their banking system scattered across multiple countries, and save their sovereign debt scattered across multiple countries. But, there is only one central bank, led by the "hard money" "tight fisted" Germans.
When the US had similar problems, the fed stepped in and reliquified banks and bought up a lot of bad mortgage debt, and soaked up extra Treasurys.
Will the ECB be able to do the same?
I will rather invest in a currency where austerity measures have already started than a country where things are just floating in LaLa land and the sheeple are high from their daily dose of cool aid. We are about to hit $13 trillion. Watch this !! http://www.usdebtclock.org/
My only question for this forecast - floaters or sinkers?
Where could you be wrong?
There is fundamentally more $ debt to deflate than € debt to deflate? And, isn't the € the new favorite funding currency of the "carry trade?"
May 21, 2010
... Analysis by the Ifo Institute for Economic Research at the University of Munich concludes that contrary to some contentions there is no systemic crisis of the single currency the euro. In fact, the euro is still overvalued in terms of purchasing power parity. Its true value lies at around $1.14. Also the inflation rate shows no indication that the currency is in danger, since at a current 1.5 percent it is clearly below the average rate of inflation that prevailed for the Deutsche mark...
http://www.thelocal.de/opinion/20100521-27345.html
more like $.95 if you factor in the 19% VAT :>)
Could this be a better redaction:
Thought so...