On this last day of August, the euro dropped to a new historical low (EUR/CHF ±1.295) related to the Swiss franc. We could ask ourselves what could this tell us about the euro and its implications?
I’ve thought, as we are closing in on the end of this summer in the Northern hemisphere, it could be helpful to take a look at recent currency developments in the eurozone and elsewhere.
The months of June, July and August have provided us with some valuable information on the forces driving the euro. It is now clear that although the structural problems facing the eurozone and the euro itself remain a dominant theme, other issues continue to lurk just beneath the surface.
This became clear through June and July when, in the face of a moderate easing in tensions in Europe, the fragile state of the U.S. economy very rapidly became the driving force for the markets for a time.
It also seems clear from the available evidence that Chinese currency and reserve polices may well have shifted significantly in the past few months in ways that aren’t fully understood yet.
Meanwhile, the topic of FX intervention has continued to “stalk” the Swiss franc as well as the Japanese yen and implies the threat of becoming a major issue in the immediate future.
For investors, the big question is if we could make sure (somewhat) we understand each of these key stories, and how they are interacting with each other, and then we could be in a better position to work out what could happen through the remainder of 2010 and well into a good part of 2011.
Looking back we see during this past decade the euro’s stellar performance of about 75 percent appreciation against the U.S. dollar between January 2002 and March 2008 that had in fact very little to do with the economic performance of the eurozone itself or even with the yields in euro that were available in that period.
In reality, it practically came down to the outlet that the region’s sovereign debt markets provided to FX reserve managers looking for credible alternative homes to the U.S. for their ever-rising reserve holdings.
Through the early part of this 2002 – 2005 period, the evidence from flow data as noted in New York indicate that much of this buying was focused on the major “northern” European markets.
However, as reserve growth accelerated sharply from the start of 2005, according to the IMF’s COFER (Currency Composition of Foreign Exchange Reserves) numbers, increasing amounts of this money began to flow into peripheral PIIGS markets (Portugal, Italy, Ireland, Greece and Spain) in an attempt to further diversify holdings as well as picking up additional higher yields without taking into account the underlying values of the different sovereigns.
Then, by the summer of 2007 the net result of this powerful force was that benchmark sovereign yield gaps within the eurozone had shrunk to negligible, if not laughable, levels.
By implication, this also meant that many investors had begun to treat peripheral eurozone countries’ (PIIGS) sovereign debt as if they were all the same as that of Germany, the Netherlands, Austria, etc.
Although confidence in this belief started to get fully undermined in early 2009 during the time of the Irish crisis, it was the news that Greece had been put under EU supervision in December 2009, following an announcement by the new administration in Greece that the public deficit for 2007 had to be “revised” upward to reality that meant up to 12.5 percent of GDP, that finally shattered this comfortable illusion that all eurozone sovereigns were equal.
Some well managed eurozone government bond auctions and a marked deterioration in the outlook for the U.S. economy served to take the pressure off the euro through summer, the news from within the eurozone made it clear that a dramatic recovery in the fortunes of the peripheral nations along, of course, with their financial institutions, looks unlikely at any point in the near future.
Investors must take notice, for example, that Spanish banks took 130.21 billion euro (US$166 billion) in funding from the ECB in July, up 3 percent from June while Greek banks boosted their borrowings in July by about 2.5 percent month on month. Portuguese banks saw their borrowings from the ECB increase by about 21 percent and Italian banks took an additional 12 percent.
August also saw fresh concerns about the Irish banking system start to emerge, leading to a fresh downgrade of its sovereign debt rating by Standard & Poor’s to AA minus.
Meanwhile, there is growing uneasiness over quite how high Greek, Spanish, etc., unemployment will further rise in the months ahead now that the southern European tourist season comes to an end this fall.
The just released eurozone area seasonally adjusted unemployment rate that came in at “unchanged from June” 10.0 percent in July 2010 shows the lowest unemployment rates were recorded in Austria (3.8 percent), the Netherlands (4.4 percent) and Germany (6.9 percent) while the highest rate was noted in Spain (20.3 percent).
The youth unemployment rate (under 25) that came in at 19.6 percent in the eurozone area shows the lowest rate was in the Netherlands (8.1 percent) and the highest shocking rate was seen in Spain (41.5 percent).
Believe me, that’s not a good omen.
We could argue that none of this should be seen as being terribly surprising given the structural nature of the problems facing the eurozone countries in particular.
Moreover, the price movements seen in all the relevant markets in recent weeks, from the continued strengthening of the Swiss franc (CHF) to the upward pressure seen in the key eurozone government bond spreads, are consistent with the long term downward reassessment of the euro that now has been under way since January.
However, I have also learned so far this year that possibly the best leading indicators of developments in the euro and underlying debt markets have been the New York flow data.
I therefore find it telling that while outflows from Greek debt remain modest for the moment, we also observe continued outflows from Italian debt and renewed selling of Portuguese debt. More importantly, we have also begun to register significant fresh outflows from the euro itself at the sort of pace we were seeing through much of the first quarter of this year.
Given the scale of the buybacks we registered through June and July, however, there is still plenty of space for this trend to develop further. Given this, I therefore wonder whether the growing concerns about the refinancing of Irish and Spanish bank debt through September could provide the catalyst for just such a move.
Taking all this into account and besides the further negatively developing political problems like public discontent inside the eurozone, I have no doubt the euro is bound for moving back, notwithstanding very few believe this, to the zone of its 2002 -2004 levels that are roughly between the “extremes” of 90 cents and $1.20 per euro.
I’m convinced the euro will be one of the big (disturbing) players and “real” all-market movers (positive or negative depending on what side you’re on) for the coming autumn (in the Northern hemisphere) and well into 2011.
In my opinion, risk aversion will once again become king, which will mean dollar up and euro and “a lot of other markets” down.
Of course, this is only my personal opinion.
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