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Assuming the Euro Area Is a De-Facto Fiscal Union Is a Very Dangerous Assumption

Tuesday, 18 February 2014 01:23 PM Current | Bio | Archive

After President Obama signed legislation on Saturday that raises the U.S. debt ceiling through March 15 of next year, I think it's fair to say serious, politically created "potholes" on the slow road to U.S. recovery have only an extremely slim chance to cause damage. However, there still remains a lot of work to be performed at all levels of the economy for making the recovery really "sustainable" by bringing down the "structural" unemployment situation that will, at best, take much more time than many are thinking today; inciting small and big business to start finally raising their capital expenditures; etc.

That said, I still see, at least for now, the United States as one of the most secure and promising places on the globe for investment, which doesn't mean "per se" (by itself) you should be over-exposed to U.S. stocks at this moment. I still expect a sizable correction within the foreseeable future and surely within the next few years and that could easily be remembered as another "Great Crash." Of course, this is not written in stone.

Canada, Norway, Switzerland, etc. are in my opinion also defendable places, including their respective currencies, that will keep their long-standing merits for shielding your investments in a diversified and balanced portfolio. But this doesn't mean the nominal values couldn't be temporarily in "overvalued" territory and, if that's the case, you'll have to be patient and wait until the markets correct, which they always do over time. No, never go into competition with time!

Nevertheless, in developed economies it must also be recognized we still face a way-too-slow recovery, especially in the euro area, undischarged astronomical amounts of hidden debts, stagnant real wages in many places and, to put it simply, any form of back-to-reality recalculations.

For the time being, I still would prefer to leave the emerging economies complex alone and take my time until still lower price levels (-25 percent or even more) take hold before considering stepping in. By the way, I don't expect this to happen any time soon.

China remains to me, in the context of a long-term investor, excluded of considering investing over there now as long as we haven't seen its extended range of announced "deep" reforms being applied in their "real" and "verifiable" world. Yes, there are too many foggy situations in China. Again, long-term investors shouldn't expect the skies to clear up overnight.

Coming to the euro area for a moment, it must be admitted that many investors don't understand why the euro has done so well against the dollar.

The strong performance of the euro becomes even more interesting when we take into account the International Monetary Fund's Currency Composition of Official Foreign Exchange Reserves that showed as late as Dec. 30 an undisputable lack of interest for the euro from the central banks themselves or, more generally speaking, a lack of interest in the single currency that is equally confirmed by the numbers of what's called the "real" money flows as observed in New York.

It's an undeniable fact that with bond yields through most of the developed world still or close to record lows, the yields of the euro area periphery countries offer continuously one of the very few places that presented returns to those (believe me, and here we are talking about huge numbers!) that play the carry trade in the context of searching for yield.

As an example, we could mention the currency exchange pair of euro/Japanese yen, which has provided a fairly neat mirror of the way that the yield gap between Portuguese and German 10-year government debt has narrowed since July 2012 when European Central Bank (ECB) President Mario Draghi said the bank would do "whatever it takes to preserve the euro." Six weeks later, these words were then backed up by the ECB's conditional bond-purchase program called the Outright Monetary Transactions (OMT) that came into force, and which, by the way, has never been used so far.

As we all know, yield seeking has continued all over the place, and in the euro area, key yield gaps have continued to come down to 2010 levels and are not yet at but very close to pre-euro area crisis levels. It's interesting to take notice that the Irish/German 10-year yield gap is now where it was the second half of 2009.

One could say all this should be considered as very positive news given that it shows investors as well as speculators believed Draghi.

Now, in my opinion at least, this is a dangerous form of believing and the contraction of all those yield spreads to close to pre-crisis levels is an undeniable indication that many assume the euro area bond market is back to the conditions that governed it prior to 2010.

Nothing could be further from the raw reality and I don't think it's an overstatement to say the seemingly broad belief the euro area has become a de-facto fiscal union is bluntly wrong, notwithstanding Greece, which has indeed been rescued, albeit only in part.

Assuming the euro area is a de-facto fiscal union is in my opinion a very dangerous assumption that could cost any investor over the near to medium term dearly.

Earlier this month, the German constitutional court stated: "There are important reasons to assume it [OMT] exceeds the ECB's monetary policy mandate and thus infringes the powers of the Member States, and that it violates the prohibition of monetary financing of the budget."

However, the German constitutional court refrained from issuing a final ruling on the legality of the ECB policy, although it certainly created the possibility that the German Bundesbank could find itself legally barred from becoming involved.

The German daily "Der Spiegel" stated: "Germany's Constitutional Court ruling last Friday marks a significant escalation in efforts to rein in the European Central Bank. The ruling's message? Either the European Court of Justice has to stop bond purchases or German justices will."

All this doesn't mean the euro area is closing in on the dawn of a renewed euro crisis. Nevertheless, in my opinion there should be few doubts the best times for the "carry supported" strong euro are quickly coming to their end.

Anyway, only a few days ago, German Chancellor Angela Merkel blocked a bid by her powerful Finance Minister Wolfgang Schauble to offer fresh aid to Greece as a "demonstration of solidarity."

Merkel knows very well that such kind of aid to Greece wouldn't have pleased the growing number of "euro critics" and certainly would have helped them in the coming European parliamentary elections on May 25.

What could happen after the EU elections is still anybody's guess.

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Assuming the euro area is a de-facto fiscal union is in my opinion a very dangerous assumption that could cost any investor over the near to medium term dearly.
Tuesday, 18 February 2014 01:23 PM
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