Brown Brothers On Intrinsic EUR, and European, Weakness

The split between pundits on the fate of the key FX pair: the EURUSD, has rarely been more diametrical. On one hand you have the Steven Englanders of the world calling for a major drop in the USD, on the other, you have firms like Brown Brothers saying the USD is poised to surge. Ultimately, the arbiter will likely end up being China, and what grade the world gives to Bernanke's actions. In the meantime, here is BBH on their view of why the EUR is likely overpriced at these points. Surely, this is a view that would be very much endorsed by all of Germany, and since the EUR did its penance as the world's most overpriced currency long enough, we would not be surprised to see much more of the European weakness make headlines once again.


Our expectation for a dollar recovery was not only predicated on the market having discounted all the bad news and being vulnerable to a better string of economic data, but also that the situation in Europe is not as good as some are inferring from the euro’s appreciation over the past few months.

The unresolved debt dynamics are resurfacing. Greece, for one, (which has its own EU/IMF program separate from the EFSF) is the worst performing bond market in the euro zone (10-year yield is up 133 bp in the past month and the 2-year yield is up a little more than 200 bp) followed by Ireland, which has sufficient funds on hand to last toward the middle of 2011 (10-year yield is up 113 bp in the past month and the 2-year yield is up almost 45 bp).

Germany is insisting that after the EFSF expires in 2013, there will be no more bailouts. The cost of leaving the monetary union is prohibitively great. That would seem to leave only one option to resolving the intractable debt situation. Germany calls it burden-sharing with the private sector, created to minimize the taxpayer’s exposure, while forcing creditors to accept larger haircuts. But, overall, it is debt restructuring plain and simple.

The investment implications are driving funds into Germany and driving down interest rates. The US-German 2-year interest rate differential snapped a five week trend in Germany’s favor on November 5 and at 55 bp, the premium Germany offers is smaller than its 4-week moving average for the first time since early September.

The lifting of the political and economic uncertainty that hung over the US, coupled with the somewhat better economic momentum, may allow the devolution of the situation in Europe to move into ascendancy. This was the basis of our call for the dollar to recover in the second half of the fourth quarter. While we are constantly monitoring developments, the script is thus far unfolding largely in line with our base case.

As for the dollar, here is how Marc Chandler highlights the upside case.

One of the most striking aspects of QEII is that it is happening at all. The consensus forecast for US growth next year is around 2.5% with a 1.5% CPI. Most high income countries would regard this as quite a favorable outcome and surely not one in need of extraordinary monetary stimulus. Yet the Bernanke Fed says that it is not satisfactory because its legal mandate of full employment and price stability will not be achieved in a reasonable time.

Nevertheless, the idea that the money that the Fed creates to buy those billions of dollars of Treasuries will flow out of the US and into emerging markets is mistaken. The US current account deficit means the US runs a capital account surplus. This means the US is a net importer of capital, not an exporter.

In fact, the US TIC data records not only foreign purchases of US financial assets, but also US purchases of foreign financial asset with the most recent data from the month of August. Over the first 8 months of 2010, for example, Americans bought $80 bln of foreign stocks and bonds. In the last three months, the purchases slowed to total of $10 bln. By comparison in the first 8 months in 2009, Americans had bought almost $100 bln of foreign bonds and stocks and in the three-month period through August bought $64 bln. If emerging markets are being inundated with capital, it is not coming from the US.

As usual, our condolences to FX traders, where 200 pip daily moves are now the norm. Apply 500x leverage and you can see why Wall Streeters do their best to retire in the early 30s.


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