Euro: Currency of the Year?
02/13/2013 9:15 am EST
Axel Merk of Merk Insights puts the spotlight on the euro and explains why in the latest currency wars, it may be down but not out.
First, for some background: We were positive on the euro in 2010, when the currency was tumbling towards 1.18, arguing that the issues in the Eurozone were rather serious, but should primarily be expressed in the spreads in the bond markets.
The euro, we argued, was sold as a proxy, as it was easier to short than peripheral Eurozone bonds. Sure enough, the euro recovered to the high 1.40s while spreads were blowing out.
We then turned gradually negative in the fall of 2011, noting that the processes to adjust the crisis were increasingly dysfunctional. If you don't know what direction management is taking a business in, investors stay away from buying shares in the company, as they cannot price the risks. Similarly, a bad process is better than no process when it comes to dealing with the challenges in the Eurozone crisis.
In the spring of 2012, European Central Bank (ECB) President Draghi implored policymakers to define roles, set deadlines, and hold people accountable. In good political fashion, nothing happened.
What got us positive on the euro, though, was Draghi’s announcement that the ECB would buy peripheral Eurozone bonds should such countries ask for help, and other countries agree to help. The move was ingenious for a number of reasons, including:
- It provided a process to move forward. For all the naysayers, keep in mind that the processes in the US, UK, and Japan aren’t particularly good either.
- The euro took great strides to becoming “yet another currency”—very good news for a currency that’s been treated like a contagious disease.
- The process requires that weak countries would give up sovereign control over their budgeting.
- The fact that other Eurozone countries have to agree to help weak ones throws the ball into the court of politicians. Many disagree with us that the ECB is truly able to stay outside of politics, but in our assessment, the ECB is better positioned to deal with political pressure to finance deficits than the Federal Reserve, Bank of England, or Bank of Japan.
- Not to be ignored, Draghi did remove significant “tail risk,” making it much less likely that we will see liquidity-driven defaults. I’m treading carefully here in how to express this, as I believe the essence of many of the Eurozone policies is to eventually have markets strong enough to stomach sovereign restructurings. As such, I’m not ruling out defaults in the Eurozone. But when the time comes, the market fallout may be rather limited.
In brief, the ECB promised to act more like other central banks if Eurozone countries acted more like a United States of Europe.
This does not mean everything is well in the Eurozone. The lack of further progress is mostly due to some slacking off as bond market pressure has abated in the periphery. A scandal alleging that Spanish Prime Minister Rajoy has taken bribes is a symptom of how fragile peripheral Eurozone countries continue to be.
Italy’s next government is likely to be weak as populist politicians continue to be on the rise. As a result, the tone is a more somber one after euphoria of late. We call it profit-taking. Clearly, the ascent of the euro won’t be a straight line.