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All Signs Point to Dollar Rally, Euro Trouble

Friday, 13 August 2010 03:01 PM Current | Bio | Archive

Less than three weeks after passing Europe's bank stress test, the Irish banking sector shows serious problems once again.

The European Commission was obliged to give an additional 10 billion euros ($13 billion) in capital for state-owned Anglo Irish Bank, on top of the 14.3 billion euros ($18.5 billion) the bank had already received earlier.

Also this week, the Bank of Ireland, which is 36 percent owned by the government, reported a pretax first-half loss that is nearly twice as big as its loss in 2009.

We can easily say that the troubles in Ireland never went away, as is the case for the other weaker PIIG countries of the eurozone.

Meanwhile, in what is extremely important for where the eurozone will go from here on, the European Statistical System, or Eurostat, has required Germany to include the balance sheets of its public-owned bad banks that were set up to help financial institutions offload toxic and nonstrategic assets into its overall debt ratio.

State-owned WestLB AG bank has already offloaded 77 billion euros ($99.5 billion) into such a rescue bank.

In accordance with the Eurostat decision, 54 billion euros ($70 billion) of WestLB's toxic assets transferred to the bad bank must be included in Germany's overall debt level. If the already nationalized mortgage lender Hypo Real Estate is added to the equation, then Germany's debt level could widen to 90 percent of its GDP, which would be much higher than the 60 percent threshold set under the European Union's Maastricht Treaty.

Yes, this points to trouble in the making once again, taking into account that Germany wants everybody to “live by the rules.”

In my opinion, we are back in the “pre-June world” as tensions are popping back up in the eurozone debt market.

The “new” situation (which is nothing different from the “old” situation) has also, unfortunately, been exacerbated by the FOMC’s gloomy assessment on Tuesday.

The sovereign yield spreads over the German bunds remain at elevated levels and have even risen further in the case of Ireland, Spain and France, among others.

And if all that wasn’t enough, we now also see the European Union governments of the right, left and center appear at risk to crumble as a consequence of their eroded positions that have been, and continue to be, caused by a wave of austerity, high unemployment and government debt, plus a smattering of nasty corruption scandals.

When we look for a moment at the five most important countries that represent roughly 75 percent of the European Union GDP we see, even when we set their national debts aside for a moment, an enormous degree of political instability emerging in these economies that will create serious doubts about where the European Union could go from here on.

So, let’s take a look:

• In Germany, one of the costs of bailing out the Greeks earlier this year appeared to be the career of Chancellor Angela Merkel. It’s too early to write her off, but voters sharply rebuked her Christian Democrat-led coalition in local elections in July, depriving her government of control of the upper house of parliament. Since the election, Merkel’s own poll numbers have slipped, and trouble has emerged inside her coalition.

• In Italy, Prime Minister Silvio Berlusconi lost his parliamentary majority due to the defection of a 30-strong faction from his People of Freedom party over a junior minister accused of corruption. Berlusconi, who has been in power since 2008 (after leading in 1994-95 and 2001-06), probably will face a vote of confidence in September. As of right now, new elections in Italy seem more likely than not.

• In Spain, the European country staring most intently into the economic abyss, Prime Minister Jose Luis Rodriguez Zapatero’s coalition is dependent on two nationalist parties that know they have him in a spot. Ahead of the Catalan regional elections in October and November, both the Catalan Party and the Basque Nationalist Party want concessions on regional autonomy that the rank-and-file of Zapatero’s Socialist Party oppose. The Catalan nationalists also want to see more and deeper reforms of labor laws and social programs and could be tempted by a coalition with Zapatero’s rival, People’s Party leader Mariano Rajoy, who now trumps Zapatero in opinion polls. By the way, Zapatero is already considering “easing” some of Spain’s austerity measures.

• In France, meanwhile, another mercurial continental leader, President Nicolas Sarkozy, finds himself embroiled in a campaign finance scandal that could threaten his job. Sarkozy came into office declaring that a new era of probity had dawned. But French police have opened investigations into whether Sarkozy solicited large political donations from 87-year-old Liliane Bettencourt, the wealthiest woman in France and heiress to the L'Oréal cosmetics fortune, which bears the potential of explosive implications for the implementation of Sarkozy's highly unpopular austerity package.

• In Britain, the election that ended 12 years of Labor rule in April brought to power not the Tories but rather a Tory-Liberal Democrat coalition, an uncomfortable and somewhat unprecedented situation for the British. The deals each side cut have a one-year shelf life — basically, until the referendum on electoral reforms that the Liberal Democrats insisted on can be held next May. After that, watch how quickly the coalition unravels.

In my opinion, the dominant picture doesn’t look nice at all and I don’t expect “positive” surprises in the near term. On the contrary, I expect a lot of negative confirmations of a lot of uncertainties.

All this will favor the dollar, for now at least. I wouldn’t be “long” the euro and the British pound.

Investors that have British pounds face growing uncertainty from an economic and policy perspective, and this can hardly be seen as supportive of the British pound.

Of late, the market has arguably chosen to take a Panglossian view on the U.K. economy, which, in conjunction with broad-based dollar weakness, has seen GBP soar. But the gradual easing in the British pound index since the start of the month has complied with a well-defined narrowing range that has become firmly established during the past year and a half.

It is too early to draw any firm conclusions in this market about the sustainability of this trend, but then this week’s Bank of England or BOE Gilt auction — which saw a bid to cover ratio of just of 1.56, down from 1.87 last time around — is perhaps tentative evidence that investor confidence in the United Kingdom is not quite what it was.

On the euro, as I already said earlier this week, I’m convinced the “EUR-USD top” is in and I expect a sizable decline in the euro that could easily be headed well below the June low at 1.1876. Of course, we should move down in waves including minirallies that will present good opportunities to sell the euro further.

The impulsive upturn in the Dollar Index since last Friday is to me confirming evidence that an important low in the 79.51-81.44 support range has formed.

Last week we saw the Daily Sentiment Index, or DSI, hit 6 percent bulls, which was a lower reading than the low seen in November 2009.

I’m now confident that a trend change in the dollar has occurred. On the dollar’s way up, retracements could be used as buying opportunities.

Yes, I see the dollar going higher from here on, at least for now.

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Less than three weeks after passing Europe's bank stress test, the Irish banking sector shows serious problems once again. The European Commission was obliged to give an additional 10 billion euros ($13 billion) in capital for state-owned Anglo Irish Bank, on top of the...
Friday, 13 August 2010 03:01 PM
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