Should You Buy or Sell the Euro?
03/22/2013 9:00 am EST
Cyprus’ decision to tax bank deposits is throwing chaos into the markets, especially the prospects for the euro, writes Axel Merk of Merk Investments.
Last summer, in return for ceding sovereign control over budgets to Eurozone partners—i.e., for political integration—European Central Bank President Draghi promised the ECB would act more like a “normal” central bank, buying Treasuries of nations asking for help.
Draghi’s announcement not only turned the euro around, it reversed the capital flight from the “periphery” to the “core” of the Eurozone, meaning from weaker to stronger countries.
Beyond that, it triggered a change in global market dynamics: Risk on/risk off correlations melted down way beyond the currency markets, forcing investors to start thinking again rather than merely chasing trends. When the markets were in a good mood, money went to the Eurozone rather than commodity currencies associated with “risk on” in recent years.
Draghi clearly reduced the chances of a variety of tail-risk scenarios unfolding. In an environment where the euro was most unloved, with risks reduced, we were buyers. Our argument was that this year, the euro should benefit as the normalization process continued, fully realizing that the process wasn’t perfect.
What we were underestimating was the extremes to which policymakers in the periphery would go to retain power. Prime Minister Rajoy in Spain would rather raid the pension funds than open Spain’s books to EU bureaucrats. And in Cyprus, the prime minister would rather seize assets of small-time savers, in an effort to maintain its business model of attracting money from Russian oligarchs.
The Eurozone, often in conjunction with the International Monetary Fund (IMF), is willing to help. Yet Germany in particular was not willing to bail out Russian oligarchs in Cyprus.
When the nation of merely 1.1 million people needed an astounding €17 billion to bail out its banks, €10 billion in aid was offered, with the remainder to come from Cyprus itself. Time had run out for a government debt restructuring.
Banks in Cyprus almost exclusively rely on deposits to fund themselves, and have few, if any, other creditors that could have been asked to take a “haircut.” So they came up with the idea of taxing all deposits, including “insured” deposits of less than €100,000. Not only may it be political suicide for those voting in favor of the scheme, but others in Europe may well fear that their deposits might be next.
Of course, Cyprus is “unique,” but the damage has been done, even if an eventual compromise ends up protecting some, or all, small deposits. By dragging out a decision, even a bad one, ever more confidence is eroded.
According to Bloomberg, since 2008 depositors in Cypriot banks earned about double the interest of depositors in German banks. Weak banks attract capital by offering higher yields.
If investors thought a bank run beyond Cyprus were to ensue, gold should be much higher. But then again, the subprime crisis was, in the eyes of our dear central bankers, also initially “contained.” As such, this most recent episode serves as a reminder that gold may play an important role as a diversifier in investors’ portfolios.
The euro, in our assessment, is cheap. The question is whether it is going to get a lot cheaper or whether it will appreciate from here.
Cyprus highlights the weaknesses in Eurozone decision-making. For that, the euro deserves to weaken in the short-term. But the assurances that this is unique to Cyprus also make sense, at least for now.
However, another seed of uncertainty has been planted. Risk-friendly capital chasing yields in the Eurozone better be on alert: The word “risk” does, indeed, mean that capital is at risk.