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.
YEN FOR DEFLATION
The IMF has projected Japan’s gross debt for 2010 at 227% of its annual GDP, reflecting continuation of a trend that’s kept the country in a deflationary period for years.
“The Japanese have said over and over again that they’re committed to battling deflation,” says Hoversen. “Whether that means increasing their QE (quantitative easing) program or deploying another round of emergency policy tools I can’t say, but their rhetoric indicates they’re very much ready to do both.” She points out that the recent Economy Watchers Survey of business-cycle sensitive workers showed optimism, but not enthusiasm, and that Finance Minister Naoto Kan has repeatedly harangued the Bank of Japan for failing to take action despite projecting another two years of deflation at least.
The government set a target of 2% real annual GDP growth over the next 10 years, and Kan says that plan is contingent on an inflation rate of 1%. Neither he nor Prime Minister Yukio Hatoyama has called for an outright inflation target, but pressure to take action is mounting.
With its key interest rate at 0.1%, the BOJ’s options are limited. It has, however, twice conducted massive infusions of three-month funds to ratchet up liquidity — once in December, and once in March. The bank accepted bonds as collateral in both of those actions, and also has promised more stimulus to come. The next step might be an outright buy-back of bonds, says Holger Schindler, who manages currency risk for Hanseatisches Logistik in Hamburg.
“The BOJ really prefers to let things ride,” he says. “They want to act gently to prevent being given a mandate to set an inflation target. So, you’ll see little nudges and maybe intervention when we get above a certain level, but they don’t want to do more.”
Those interventions may not be far away. The country recently announced it would raise its borrowing limit to raise its war-chest for market interventions, a practice it gave up six years ago. The BOJ will be reviewing its long-term strategy on Apr. 30, and rhetoric surrounding that meeting will begin jostling the yen more and more as the date approaches.
THE CHINA CONNECTION
China may be the world’s largest exporter, but Germany is number two, and China is one of Germany’s largest non-EU export destinations. Furthermore, Germany’s exports to China are high-end goods and services such as factory machines and engineering expertise.
Unlike its neighbor, France, Germany hasn’t managed to create the kind of domestic demand that will sustain it in bad times. Indeed, Chancellor Angela Merkel has openly expressed an unwillingness to try and do so.
That leaves the euro at risk of further depreciation if China slows — a risk that also extends to the Australian, New Zealand and Canadian dollars. These commodity currencies have remained strong at the end of 2009 and beginning of 2010 despite the surge in the dollar. But if Chinese demand for commodities slows, these currencies will take a hit.
THE OVERSOLD POUND
The United Kingdom is gearing up for a general election to be held on or before June 3, and you can bet markets will be watching carefully as the pound continues to struggle back from a two-year slide that bottomed out in early 2009.
“As the polls get a little bit closer, anything under a 10% lead for the Conservative party is moving into hung parliament territory, and the latest polls are showing just a 5% lead, which is well within that range,” Furness says. “At the same time, there is an awful lot of M&A activity in the background, and whilst equity markets remain volatile, plenty of hedge adjustment currency trade by UK fund managers, which could mean UK buying.”
Furthermore, he says, central banks tend to buy sterling as it falls to keep their reserves diverse, a fact often lost on the market at large.
So at least some of that bodes well for the pound, but the downside isn’t difficult to see: the country has the highest budget deficit of the G7 nations, and when former IMF Chief Economist Kenneth Rogoff warned that a default in Greece could set off a chain of sovereign defaults across the developed world, many eyes turned to the UK. Indeed, as Greek woes intensify, the pound has been suffering.
Furness sees a rocky mid-term for the pound, and advises anyone looking to capitalize on the weakening euro to stick to the long dollar, although his favorite cross has been the euro/Swedish
“The krona is part of the dollar index, so it’s used in arbitrage trade,” he explains. “We’re forecasting higher interest rates for Sweden, and the Swedish central bank has been great at keeping the market fully in touch with where they think the interest rate picture is going.”
The euro has been sliding against the krona since early last year when it peaked at 11.71. At the beginning of this year, Furness’s company recommended adding to short euro/long krona at 10.30, with an objective of 9.60 by the end of 2010.
Meanwhile, back in Europe, many traders are bracing for another round of warnings about credit ratings.
“The ratings agencies, having missed everything at the beginning, are now becoming somewhat overzealous,” says Furness. “They’re slamming stable doors before the horse is even in as opposed to missing them on the way out. There has to be some form of measurement, and as such the market needs ratings agencies, but getting the balance between pre-emptive and reactive action right is difficult, and what some see as current overreaction can cause even bigger problems than those they are trying to measure. The whole thing is self-feeding, and this phase is certainly not finished yet.”
At some point, the theory goes, the bulk of the bad news truly will have been flushed into the open, and the market will shift to trading based not on the probability of hidden dangers but on the fallout from those already revealed. Only after all the bad news is factored into the market and the excess liquidity that was injected during the banking crisis is sucked back up will attention turn to interest rate differentials and other standard indicators. Most analysts, surprisingly, see normalization by year-end, regardless of how bad things get for the euro before then.
A few voices see, or even advise, disintegration of the Eurozone. Harvard economist Martin Feldstein is among them. “The rest of the Eurozone could allow Greece to take a temporary leave of absence with the right and the obligation to return at a more competitive exchange rate,” he wrote in a Feb. 17 Financial Times article.
“Even if the worst happens and the Eurozone shrinks, it will not be complete disintegration,” says Schindler. “It’s not as if the value of the euro goes to zero if Greece withdraws from the union, and it could even be a good thing to lose some of these shaky economies.”
Richard Olsen, co-founder of Oanda, has similar thoughts. “Because the Eurozone is still split into ‘sovereign’ countries, you have heterogeneity, which actually dampens the repercussions of the whole recession.”
He’s even a short-term euro bull.
THE EURO BULLS
Olsen argues that the short-term fundamentals of the dollar are weaker than those of the euro, and that the majority of traders were on the correct side of the market (namely, short the dollar) when the Greek crisis hit. Because of leverage and overconfidence, however, these fundamentally correct traders were forced to liquidate in the face of an outlier event, triggering more liquidations and more euro-selling when the fundamentals indicate they should be buying.
It’s a phenomenon he describes in a blog post, where he says that the greater the market’s confidence in a direction, the greater its leverage in that direction, and the greater the reaction against sentiment when an outlier negative event occurs.Olsen notes, “As a result, the euro bulls have been decimated because their own confidence created an exaggerated reaction to the Greek tragedy.”
And, he says, because they’re decimated, the bulls haven’t been able to buy back in until reinforcements show up in the form of new dollar bears, who he believes will be motivated by a litany of problems with the dollar that should override any concerns flowing from Greek debt. “Once you consider private-sector debt, the U.S. is in no better shape than Greece,” he says.
FINDING THE BOTTOM
Both Furness and Hoversen see the dollar topping out later in the year or early in 2011 as American woes once again take center stage, while Olsen and Schindler believe we’re near it now.
“U.S. home prices are still very depressed; you’ve still got a very high unemployment at 9.7%, and according to the IMF projections for 2010 the U.S. budget deficit as a percentage of GDP is the third-highest in the G7 behind the UK and Japan,” says Hoversen (see “Weighing the debt,” above). “But until we start seeing those threats manifest in economic data or policy or the credit markets, that’s not what the currency markets will focus on.”
She believes the euro will continue to respond negatively to non-traditional indicators such as social unrest, and advises traders to keep an eye on data that’s not normally on the front page.
“Keep an eye on bond auctions, whether they’re failing or succeeding, the real interest rates that these countries are forced to pay, as well as portfolio flows and foreign capital,” she says. “Also, be ready for positive surprises. If the financial crisis of 2008 taught us anything, it’s that governments are prone to surprise the markets with bailout packages that will serve to mitigate the risks”