This might be a provocative forecast in light of the selling pressure on the USD and the
divergence in monetary policies between the European Central bank and the US Federal
Reserve. In the same vain, in November 2008, while Gold was selling at $ 731, we
forecasted it to reach $ 1500 in two years time as we saw budget deficit levels surging to
over 10% of GDP in many developed nations.
Today investors look at the very different path of monetary policies between the US and
Europe as the main driver for the relative strength between currencies. In Europe, the
central bank started to tighten its monetary policies and governments are also
implementing material spending cuts after the financial crisis led to a surge in deficits and
public debts in Southern Europe and Ireland.
In the US, the path is completely different. The US government is late in implementing
budgetary cuts and the central bank keeps a very loose monetary policy and reaffirmed
recently that while the second wave of quantitative easing will stop in June, it will keep
rate low for a longer period of time. The normalisation process in Europe is more
advanced as is the commitment to cut deficits. The market and investors are therefore
favouring the EUR as the ECB and European governments are more committed to fight
inflation and cut spending. However, nobody knows today which of the policies is right.
The prospects of a policy error in Europe or in the US have increased.
In the US, the FED Chairman (who is probably one of the greatest economist expert
regarding deflation), believes that fighting a deflationary spiral is much harder than
fighting inflation. He is therefore more comfortable being wrong on inflation than risking
the US economy entering a deflationary period. The Fed policy reflects that and therefore
is a pro growth policy. Growth and a little bit of inflation is the best way to deal with the
current debt issue. A deflationary environment will create an unbearable weight for the US
and will lead then to a real and long lasting debasement of the currency.
The situation is therefore complicated and while there are ample reasons to start
normalising policies, the consequences of being wrong could be very material. The FED
would like to be “sure” that the economy is on a self sustainable path before normalising
policies. By doing that the FED is ready to take the inflation risk.
In Europe the situation is quite different and is mainly a political issue. The overall debt
level is lower than the US but the EUR has failed in its internal working. Governments had
to abide to strict rules in running their budget and debt levels. The financial crisis has
revealed that Greece cheated in providing false statistics, while Ireland who used to run
conservative fiscal polices had to bail out its banking system and now has huge public
debts. Portugal and Spain were also hit as their economies were boosted in the boom
times by a construction sector that almost vanished.
The pressure to put the house in order is therefore much higher in Europe as Germany is
pushing the so called “PIGS” countries to cut their deficits, repay their debts and
restructure their economies. The adjustments are clearly necessary but one can argue
about the pace of these adjustments. On top of these developments, the ECB started to
tighten its monetary policy which led to a surge of the Euro.
Now Spain and the rest have to face higher rates, sharp deficit cuts and stronger Euro.
The risk is that the effort is too harsh and that these countries will face a deflation spiral
that will make the restructuring of their debt inevitable.
Uncertainties and the market reaction reflect that. While the EUR is very strong vs. the
USD, bond investors have started to price-in higher probabilities of debt restructuring.
Yields on Greek’s 2 year bonds have reached 22.6%. One can see that spreads vs.
German government bonds have increased materially in most PIGS countries except
Spain. The market expects therefore some debt restructuring which contradicts a stronger
EUR.
A “controlled” debt restructuring could be positive for the EUR as investors will bear the
blunt of the write offs and not the European taxpayers. But what about European banks,
what about the risk of contagion to Spain, what about the ECB’s balance sheet?
Spanish bonds have not seen their spreads vs. Germany widen too much. Investors
believe therefore that Spain’s plan to cut its deficit is credible. While the Spanish
government has been very pro-active in dealing with its problems, we see the following
challenges for Spain:
- the dependence of the economy on the construction sector (over 16% of GDP) and
therefore the lack of a growth engine for many years
- the disarray state of housing with housing prices not properly reflected in banks’
mortgage assets.
- 97% of Spanish homeowners having variables mortgages rates. The ECB rate
hikes will impact negatively disposable income, lower housing prices and raise the
prospect of more defaults.
European government bond yields
% % Basis point
2Y 10Y
6 months
changes 10
Y
Germany 1.76 3.2 74
Greece 22.6 15.2 467
Portugal 11.4 9.3 9.3
Spain 3.3 5.4 115
Ireland 11 10 308
Bloomberg 29/4/11
Europe will have to make important decisions. It is not going to be easy, as decision
makers will have to report to their people. The ultimate solution could be a Federal
Europe.
In conclusion, the volatility in the FX market is expected to remain very high. The level of
macro and political uncertainties are very important.
Forecasting in this environment is a difficult exercise. We have had in our team numerous
debates about it. There are very good reasons for the depreciation of the USD vs.
fundamentally strong currencies, but the strength of the EUR vs. the USD does not reflect
the very important fiscal and political challenges that lie ahead for Europe while it seems to
have already priced-in the loose monetary policies of the FED. The near term momentum
is still in favour of the EUR as investors look at the rate differential but the European
sovereign crisis is not yet resolved and the market could be too complacent on this issue.
divergence in monetary policies between the European Central bank and the US Federal
Reserve. In the same vain, in November 2008, while Gold was selling at $ 731, we
forecasted it to reach $ 1500 in two years time as we saw budget deficit levels surging to
over 10% of GDP in many developed nations.
Today investors look at the very different path of monetary policies between the US and
Europe as the main driver for the relative strength between currencies. In Europe, the
central bank started to tighten its monetary policies and governments are also
implementing material spending cuts after the financial crisis led to a surge in deficits and
public debts in Southern Europe and Ireland.
In the US, the path is completely different. The US government is late in implementing
budgetary cuts and the central bank keeps a very loose monetary policy and reaffirmed
recently that while the second wave of quantitative easing will stop in June, it will keep
rate low for a longer period of time. The normalisation process in Europe is more
advanced as is the commitment to cut deficits. The market and investors are therefore
favouring the EUR as the ECB and European governments are more committed to fight
inflation and cut spending. However, nobody knows today which of the policies is right.
The prospects of a policy error in Europe or in the US have increased.
In the US, the FED Chairman (who is probably one of the greatest economist expert
regarding deflation), believes that fighting a deflationary spiral is much harder than
fighting inflation. He is therefore more comfortable being wrong on inflation than risking
the US economy entering a deflationary period. The Fed policy reflects that and therefore
is a pro growth policy. Growth and a little bit of inflation is the best way to deal with the
current debt issue. A deflationary environment will create an unbearable weight for the US
and will lead then to a real and long lasting debasement of the currency.
The situation is therefore complicated and while there are ample reasons to start
normalising policies, the consequences of being wrong could be very material. The FED
would like to be “sure” that the economy is on a self sustainable path before normalising
policies. By doing that the FED is ready to take the inflation risk.
In Europe the situation is quite different and is mainly a political issue. The overall debt
level is lower than the US but the EUR has failed in its internal working. Governments had
to abide to strict rules in running their budget and debt levels. The financial crisis has
revealed that Greece cheated in providing false statistics, while Ireland who used to run
conservative fiscal polices had to bail out its banking system and now has huge public
debts. Portugal and Spain were also hit as their economies were boosted in the boom
times by a construction sector that almost vanished.
The pressure to put the house in order is therefore much higher in Europe as Germany is
pushing the so called “PIGS” countries to cut their deficits, repay their debts and
restructure their economies. The adjustments are clearly necessary but one can argue
about the pace of these adjustments. On top of these developments, the ECB started to
tighten its monetary policy which led to a surge of the Euro.
Now Spain and the rest have to face higher rates, sharp deficit cuts and stronger Euro.
The risk is that the effort is too harsh and that these countries will face a deflation spiral
that will make the restructuring of their debt inevitable.
Uncertainties and the market reaction reflect that. While the EUR is very strong vs. the
USD, bond investors have started to price-in higher probabilities of debt restructuring.
Yields on Greek’s 2 year bonds have reached 22.6%. One can see that spreads vs.
German government bonds have increased materially in most PIGS countries except
Spain. The market expects therefore some debt restructuring which contradicts a stronger
EUR.
A “controlled” debt restructuring could be positive for the EUR as investors will bear the
blunt of the write offs and not the European taxpayers. But what about European banks,
what about the risk of contagion to Spain, what about the ECB’s balance sheet?
Spanish bonds have not seen their spreads vs. Germany widen too much. Investors
believe therefore that Spain’s plan to cut its deficit is credible. While the Spanish
government has been very pro-active in dealing with its problems, we see the following
challenges for Spain:
- the dependence of the economy on the construction sector (over 16% of GDP) and
therefore the lack of a growth engine for many years
- the disarray state of housing with housing prices not properly reflected in banks’
mortgage assets.
- 97% of Spanish homeowners having variables mortgages rates. The ECB rate
hikes will impact negatively disposable income, lower housing prices and raise the
prospect of more defaults.
European government bond yields
% % Basis point
2Y 10Y
6 months
changes 10
Y
Germany 1.76 3.2 74
Greece 22.6 15.2 467
Portugal 11.4 9.3 9.3
Spain 3.3 5.4 115
Ireland 11 10 308
Bloomberg 29/4/11
Europe will have to make important decisions. It is not going to be easy, as decision
makers will have to report to their people. The ultimate solution could be a Federal
Europe.
In conclusion, the volatility in the FX market is expected to remain very high. The level of
macro and political uncertainties are very important.
Forecasting in this environment is a difficult exercise. We have had in our team numerous
debates about it. There are very good reasons for the depreciation of the USD vs.
fundamentally strong currencies, but the strength of the EUR vs. the USD does not reflect
the very important fiscal and political challenges that lie ahead for Europe while it seems to
have already priced-in the loose monetary policies of the FED. The near term momentum
is still in favour of the EUR as investors look at the rate differential but the European
sovereign crisis is not yet resolved and the market could be too complacent on this issue.
