Why Is the Euro Plummeting?
Posted by Larry Doyle on March 25, 2010 9:38 AM |
The Euro is plummeting in value because of the ongoing fiscal problems in Greece and the recent downgrade of Portugal’s sovereign credit, correct? Well, these are the most recent developments, but the problems go much deeper than that.
Although the very nature of short term mentality in a heavily dominated short term trading environment would point to these problems within Greece and Portugal as the primary reasons for the problems with the Euro, let’s work a little harder and navigate a little deeper.
First off, we need to accept the premise that we are experiencing structural changes in the context of a secular market. Our friends in Washington and on Wall Street (as well as other global financial centers) work very hard to present our current economy and market as possessing merely cyclical risk. Don’t buy it.
Global fiscal stimulus over the last year has provided enormous flows of capital at essentially zero rates of interest and driven markets for many risk-based assets sky high. Has the stimulus corrected the fundamental flaws in the balance sheets of global governments and many financial institutions? I would answer with a mix of a resounding no in terms of global governments (their balance sheets have significantly worsened) to somewhat better for selected financials. All this said, the fundamental flaws and issues embodied in the massive debts overhanging nations and economic regions remain. To this end, let’s revisit commentary I penned a little over a year ago entitled, “Why Is George Soros Short the Euro? MUST READ.”
Within the body of my commentary, I reference great work by John Mauldin and his close colleague Niels Jensen. A year ago, Jensen wrote about problems within the Euro-zone and I referenced:
Public debt to rise and rise
. . . the banking sector cannot, in the current environment at least, raise sufficient capital to stay afloat, so more, possibly a lot more, tax payers’ money will have to be put forward. This can only mean one thing. Public debt will rise and rise. The official estimate for the UK for next year is already approaching 10% of GDP, an estimate which will almost certainly rise further. We probably have to get used to running 10-15% deficits for a few years, a fact which seriously undermines the notion of government bonds being next to risk-free.
BCA Research has calculated the effect on public debt in a number of countries, as a result of further bank losses being underwritten by tax payers. Obviously, those countries with the largest banking industries (as a % of GDP) will be hit the hardest.
Don’t think for a second that market participants are merely focused on fiscal problems strictly within Greece and Portugal. The problems go much deeper. As Mauldin summarized a year ago:
…there is a real risk that investors will demand much higher risk premiums on government debt. Only a few days ago, Ireland issued 3-year bonds at almost 250 basis points over corresponding Bunds. As more and more debt is transferred to sovereign balance sheets, we will likely see the spreads between good and bad paper rise further but we will also witness increasingly desperate measures being applied by the men in power. If they could prohibit short-selling of banks on the stock exchange (which didn’t work), why wouldn’t they consider prohibiting short-selling of government bonds? Not that it would necessarily work any better, but desperate people do desperate things.
Can Germany rescue us?
Most investors remain convinced that Germany will come to the rescue – in my opinion not as simple a solution as widely perceived given the enormity of the crisis. One possible solution which has been mentioned frequently in recent weeks is for all the eurozone nations to get together and start issuing joint bonds. This would undoubtedly help the weaker nations, but the idea was shot down by the German Finance Minister only a few days ago when he said that closer economic harmony across the eurozone would be needed before Germany would be prepared to entertain such an idea.
The most obvious trick left in the book, therefore, is to inflate us out of this mess. With the enormous amounts of public debt being created at the moment, years of deflation a la Japan would be catastrophic. You will never get a central banker to admit to it, but a healthy dose of inflation is probably our best prospect of surviving this crisis.
Given this outlook, do you really want to be long euros?
Market participants are fleeing the Euro in droves. Where are they going? The safety of the U.S. dollar. But wait, the debt in our country as a percentage of overall GDP is worse than many of the Euro-nations.