Submitted by Maurice Pomery from Strategic Alpha
Keep The Faith
Why isn’t the EUR lower; central bank agreement?
The question most asked by clients is why, with all that is going on in Europe, is the currency not much lower as nearly every analysts has a target of between parity and 1.2000? It is a very good question but way back at the start of 2011 I suggested that I felt some accord had been reached by the G20 to hold the EUR stable and this I still believe. The issue is that the EU leadership and indeed all those that trade with the zone, realize that equity markets would be held up by QE and that bond yields could be kept down (wrong) using the same method but the whole house of cards could be brought down if there was a run on the currency and a general loss of confidence in the currency. It would simply be a disaster and to me it is central bank manipulation that is keeping the EUR so ridiculously strong so selling breaks to the downside has seen many karted out on a stretcher and sent to the asylum.
The point is that what will it take for a substantial fall in the EUR? Again we have seen some staggeringly bad news in the zone and some are suggesting if the EUR does finally start sliding fast it could be the biggest sign of a break-up so I guess the central banks will do what they can to hold it. Spain as we know is huge but the concerning thing here is that the contagion to Italy and possibly France (and don’t forget Sarkozy is still losing at the polls) continues and the IMF and EU bail-outs cannot take THAT hit if they all come close together. These hikes in Yield will take their toll for sure so we have to assume more easing and liquidity stuffing from the ECB. They will need to throw everything they have at this soon as to me one the most dangerous issues here is the exposure of banks to property still and nowhere more than Spain. Another financial crisis, this time led by EU banks looks a very real possibility and they face some downgrades from Moody’s in coming weeks!
But will it work? There is growing skepticism about this as it is clear the problem is not a liquidity issue here and thus the medicine may be the wrong one. We also know that austerity measures take years to effect the economy and the initial move is years of stagnant or falling growth. Germany is still doggedly against any kind of wealth transfer so an EU bond still looks unlikely. Just how much is the EU prepared to throw at this? Don’t get me wrong, Germany need a strong Europe as much as Greece do and whilst many believe Germany is the only one that can afford to leave, I doubt they will unless there is a severe change in the political structure there. But citizens within the zone, whist seeing some of the benefits in the past, are concerned that the future for them and more importantly their children looks very grim indeed. We may yet see a political backlash to all this and France may set a very dangerous precedent for the zone if Sarkozy loses.
So we must expect more LTRO’s and action from the SMP I guess but I fear the impact will be muted and yields may not fall far. The SMP has only ever slowed a daily move rather than reverse a trend and some still suggest there is no need for the ECB to buy Spanish or Italian bonds (Knott another one on Friday). Is the ECB about to go all in and flush trillions into the system with more backdoor QE? The Germans might have something to say about that and the discussions behind closed doors must be heating up. This week’s G20 meeting demands some action as markets are forcing the point but we rarely get much from these; at least publically. A strong communique is expected but I am not sure we will get more than the usual; “we are committed to the zone” rubbish. The IMF is calling for more funds but the likes of the US are looking inward and correctly do not see the IMF’s mandate as including propping up a currency regime of a group who could afford to fix it if they wanted to. Without debt forgiveness or some form of wealth transfer, these yields could explode and the speed of the move will be far greater than the speed at which they will react and agree to do something. Mind the gap!
The markets have moved this issue to another level now and the stakes have risen exponentially and EU leaders and Draghi need to focus and dump the complacency or this project is over. An imploding EU is in no one’s interest and a coordinated effort from the US to China may be needed. Is there such accord in G20? We may be about to find out if this week goes as badly as last. If massive QE is the answer (and it isn’t) then we may finally see this EUR head lower but the resolve of the central banks to stop a rout will be strong and rightly so.
With the Fed on data alert, today’s Retail sales will be monitored closely.
With the US consumer being about 70% of the US economy, retail sales matter. Interestingly consumer confidence has started to soften slightly so it will be interesting to see if spending catches up with confidence levels. If it does then Bernanke will get another wake-up call and calls for more QE from the doves may be heard. However the Fed is clearly split on this and a decision pro-actively will be hard to justify it would seem as many of the Fed voting board may demand more data. The trouble is time is running out. Quoted in the FT; Eswar Prasad of the Brookings Institution said: “The global economic recovery is still sputtering due to a lack of robust demand, policy tools that are stretched to their limits and unable to muster much traction, and enormous risks posed by weak financial systems and political uncertainty.” Again the banks remain exposed as the housing market fails to rise far off the lows and unemployment remain elevated.
Yet again I wish to highlight the difficulties facing the Fed into next year and as we all know, central banks need to plan ahead and set policy for at least a year or two ahead. The US has got to deal with its debt problem and growth will certainly be hit. So should Bernanke act now to set policy for next year or wait? I am not sure he can afford to wait and if he does he may regret it. Policy tools are now blunt and if the QE threat does not support markets then all he will have left is the Dollar! As fears over the EU rise then the US bond markets are attracting the safe haven bid and the Dollar is rising. This must surely be of concern to the Treasury and Fed alike if it goes ballistic.
If Bernanke can suggest to his voting board that unemployment (the real one not the manipulated garbage from the BLS) is rising again and that today’s retail sales suggest the consumer is deleveraging as I think he is, then he may feel that June is the latest he can act due to the upcoming election and therefore will need to communicate this soon. Thus the data today is important. With the Fed data dependent the markets will be trading nervously and we need guidance as promised by Bernanke. I fail to see how clear he has been so far as every Fed speaker seems to think differently. However Bernanke holds sway on this committee as we have seen before. Bernanke clearly believes in QE (the jury is out on this for me) and thus may feel a shock and awe effect would be helpful. The amounts would have to be massive but I believe he realises how bad next year may be.