European monetary policy/monetary conditions are too tight and, Citi's FX Technical group explains, the EURO is too strong thereby exacerbating the effects of the internal devaluation in Europe (as we noted here). Looser monetary policy and a weaker currency are becoming increasingly necessary conditions for the Eurozone to recover/survive. The present period in the Eurozone, Citi adds, where the financial architecture is coming apart at the seams is not remotely unprecedented and in fact offers a very compelling historical perspective for significant devaluation of the EUR in the years ahead.
Via Citi FX Technicals,
Given the lack of economic growth and employment growth combined with the precipitous fall in the inflation rate since July last year the ECB should be embracing looser policy and a lower EURO.
The present period in the Eurozone where the financial architecture is coming apart at the seams is not remotely unprecedented
Quick history recap:
1989-1991: We had the savings and loan crisis in the US; a sharp down turn in housing activity and a deep economic recession
1992-1994: The “travails” in the World’s largest economy found their way into the “flawed” financial architecture of Europe (The Exchange rate mechanism) which collapsed under the stress
1997-1998: Saw the “third leg” of this dynamic feed into Emerging markets as the aggressive easing in the World’s major economic zones created a “bubble” in EM and in particular Asia. Between 1989 and 1992 the Fed lowered the Fed funds rate from 9.75% to 3%.(The USD-Index fell about 27% in this period) From 1992 to 1996 the Bundesbank lowered rates from 8.75% to 2.5%.(The cycle low was put in for the USD-index in 1992 in a similar fashion to 2008 when we also reached the cycle low in the Fed funds rate) Three years later we saw the USD-index begin a 5 year plus rally-something we believe started again in 2011.
USD-index and the Fed easing cycles (Fed funds) of 1989-1992 and 2007-2009 on the back of a housing downturn, banking stress and economic downturn
We continue to believe that we are close to the next rally in the USD-index which we expect to continue for the next 2-3 years.
When we look back to that period in the early 1990’s we see a number of stimulus dynamics that eventually helped Europe “regain its footing”
Firstly the peripheral states got two distinct elements of stimulus. Most of the ERM currencies continued to weaken against the DEM into March of 1995 as the excessively tight monetary regime (Short term rates) put in place to defend the currencies was abandoned. This was further assisted by the easing of official rates by the Bundesbank from 8.75% in 1992 to a low of 2.5% by 1996.
European currencies continued to weaken into early 1995 against the Deutsche Mark.
The Italian Lira, Spanish Peseta and French Franc (Amongst many others) weakened substantially against the DEM into the spring of 1995.(Internal FX devaluation in “Euro bloc”)
As they strengthened again from 1995 onwards the Bundesbank was still lowering rates
Long term rates then started to fall sharply from 1995 and spreads converged with Germany providing further stimulus.
This move lower generated a rapid convergence of Bond yields.
Take Italy for example: Between 1995 and 1998 the 10 year Italy-Germany spread narrowed from about 650 basis points to ZERO on the back of the convergence trade.
That provided a huge monetary stimulus at the long end of the curve (And did not even need QE to do it) the magnitude of this move was much greater than what we have seen since this spread peaked just under 2 years ago.
Between 1995 and 1999 not only did we see spreads converge but long term rates in Italy (10 year) fell from 13.8% to 3.9% (Almost 1000 basis points). Compare that to today where we have seen a high to low fall of about 380 basis points between 2011 and 2013
Further as mentioned above we then saw the EURO (As its components) drop from 1.3770 in March 1995 to .8200 by October 2000 (40%) and from a peak of 1.4900 seen in 1992 (45%). Between 1995 and 1997 the convergence trade saw European currencies strengthen against the DEM (internal devaluation) but lower long term yields, short term yields and a much weaker “EURO bloc” against the USD all provided strong offsetting monetary stimulus.
Huge external devaluation for the EURO “bloc”
Sharp fall in the EURO bloc against the USD from 1995 to 2000 and in particular the 2 years from 1998-2000 (Fall of 32%)
That 2 year fall is important for a few reasons
– It happened after we had seen pretty much the “lion’s share” of the stimulative benefit of the “convergence trade” and drop in long term yields into 1998.
– The cycle low in Bundesbank rates (2.5%) in 1996 and subsequently ECB rates (2.5% in 1999) had been met at this point
Therefore the currency became the last “vestige” of monetary easing in the post ERM crisis cycle.
So reviewing the Crisis and post crisis dynamics of the ERM collapse and comparing to today
European peripheral currencies got a massive “Euro bloc” devaluation from 1992-1995. For example the Italian Lira depreciated from around 750 against the Deutsche in 1992 to about 1,240 by 1995 (About 65%). Between 1995 and 1997 some of that was unwound (internal EURO bloc) as it retraced to around 990 which became the rate at which the EURO conversion took place. That was still a devaluation of 32% from the 1992 level. Today the internal exchange rate is fixed so Italy in this crisis has had no internal devaluation.
From 1995 to 1998/1999 Italian long term yields fell precipitously (1,000 basis points) and the spread with Germany went to ZERO providing huge stimulus. During today’s crisis Italian 10 year yields have fallen from a peak of around 7.5% in 2011 to a low of around 3.7% in 2013 and now sit over 4% while German 10 year yields are around 1.75%. By definition this is much less stimulus as well as less convergence.
The EURO came into existence in January 1999 and the ECB refinancing rate hit a cycle low at 2.5% by April 1999, a move lower from the “heady peak” Bundesbank discount rate of 8.75% in 1992 and by definition large short term monetary stimulus.(fall of 625 basis points). Today we have seen a less stimulative fall from 4.25% to 0.5% over about 5 years (375 basis points with minimal future potential to fall from here)
Between 1995 and 2000 the “EURO bloc” devalued against the USD by 40% (45% since 1992). Today, if we use October 2009 as the start of this EURO crisis (The point at which peripheral yields led by Greece began to surge) EURUSD has gone from around 1.46 at that time to around 1.35 today (A net depreciation of only about 7.5%)
The bottom line here is that in all respects the stimulative post crisis dynamics this time have been much lower than those seen after a “lesser” crisis in 1992-1995.This is before we even talk about the excessive Government debt that now exists, the stresses in the European banking system, the default by Greece, the bailout of Ireland and Cyprus and the fiscal austerity measures being employed.
In addition there is minimal new stimulative potential from traditional monetary policy with ECB rates now at 0.5%.
This leaves really two major tools for further stimulative activity following this week's rate cut...
Renewed ECB bond buying (They can no longer rely on an LTRO transmission mechanism inducing financial institutions to buy European sovereign bonds especially as they have shown the propensity for haircuts when things go wrong)…this would likely then transmit into...
A sharp external devaluation of the EURO. Given the poor economic dynamics in Europe, the collapsing inflation, global feedback loop concerns regarding tapering, some concerns about the ability of China (A major export market for Europe and Germany in particular) to maintain the prior pace of economic growth etc. there should be no concern in Europe about this. The authorities have to stop viewing a weaker EURO as part of the problem (financial crisis) and more as part of the solution (External devaluation is stimulative to the MCI (monetary conditions index) and supports export led growth). Even Germany should embrace this given the sluggishness of the EURO area economies and sharply lower and falling inflation. When we look at the longer term EURUSD chart it is very supportive of this outcome in a fashion very similar to the 1995-2000 period.
URUSD monthly chart: A very compelling historical perspective
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We continue to expect a significant fall in EURUSD over the next 2+ years as we saw in 1998.We believe Europe needs and should embrace this dynamic given the ongoing danger of a deep recessionary/depressionary/deflationary environment as a consequence of fiscal austerity and the sharp internal devaluation dynamics already seen.
Within this we believe Europe should (and ultimately will) embrace the stimulative effects of such a move in conjunction with further traditional (refinancing rate) easing (Albeit at these levels the move is more psychological than anything) and non-traditional (bond buying)
On top of this the position of both the relative economic and monetary policy dynamics leaves the US further down the road and closer to a potential turn than Europe (Despite those dynamics still being weak by historical recovery standards)