It was Feb. 17, 2010, and the euro had been sliding against the dollar for two months. A week earlier, the euro had dropped through critical support as the Fed raised the discount rate it charges for emergency loans from 0.5% to 0.75%. Federal Reserve Board Chairman Ben Bernanke was about to address Congress, and many in the media were speculating that U.S. rates were about to begin creeping up across the board.
Bernanke, however, assured lawmakers that the rate adjustment wasn’t the beginning of an upward march in rates. The U.S. economy, he concluded, wasn’t ready to be weaned off low rates just yet.
It was hardly a surprising statement, but it should have sparked an immediate correction in the overbought U.S. currency – if, that is, anticipation of higher U.S. rates had really triggered the last leg of the dollar surge. Instead, the dollar continued to move higher as the world focused attention on the possibility of a default by Greece.
THE FIVE LITTLE PIIGS
At press time, the euro had stabilized on speculation that the European Union would bail out the Greeks, despite the fact that the Maastricht Treaty explicitly forbids such a bailout (just as it forbids budget deficits from exceeding 3% of GDP). Euro bears, however, point to signs of more troubles for other “peripheral” Eurozone economies like Portugal, Ireland, Italy and Spain, which, together with Greece, have been dubbed the “PIIGs.” When not worrying about the PIIGs, euro bears point to slowed exports out of Germany and worsening economic data across the Eurozone.
“If you’re trading the euro/dollar cross, it will be quite some way down the road before interest rates as a more pertinent/important indicator come into view,” says Chris Furness, director of strategy at London-based 4CAST Limited. “For now, the focus is on determining the shape and size of the iceberg, of which Greece is only the tip.”
Indeed, Portugal’s Socialist government is experiencing pushback from its own party members for austerity measures implemented in the face of staggering debt. Party leaders themselves have called for a general strike by the country’s 500,000 public sector workers, and that’s put wind in the sails of euro bears. It was, after all, unrest among Greece’s government employees (who account for a quarter of the workforce) that presaged deeper fiscal problems there.
MF Global FX and fixed income analyst Jessica Hoversen says that the risk associated with the Eurozone has been consistently underestimated for years, and points out that Greek bonds traded at only a minor premium to German bonds once the euro was introduced, even though the country’s fiscal house was in disorder (see “Hidden risk”).
“Greece basically has its hands tied behind its back,” says Hoversen. “They can’t devalue their currency to make themselves more competitive, which means they’ve really got to struggle to make themselves structurally competitive. For this to happen, the public sector will have to undergo dramatic retrenchment.”
A bailout of Greece could, therefore, not only shift attention to the other PIIGs, but also calls into question the validity of the Maastricht Treaty. And, even if austerity measures are implemented without a PIIGs revolt, the specter of deflation will put a damper on interest rates once concerns normalize.
These factors all zeroed each other out on March 4, when a successful Greek bond auction failed to spark even a modest and still overdue short-covering rally in the euro.