The euro needs crises
The euro is a strange beast as it is effectively a stateless currency backed by a union of sovereign countries. The markets were given a sharp reminder of that weakness at the beginning of the week as political problems once again flared up in the Eurozone's periphery. But such eruptions have actually proved beneficial for the single currency over the long-term.
To see that you only need look back to the summer of last year when the European Central Bank, actually started behaving more like a proper central bank when it declared it would do whatever it takes to save the euro – a rally quickly followed. This is typical of the union's history; its integration is driven by crises and it's ultimately what markets want if they are to have faith that the euro will still be around a decade from now.
Therefore the momentum behind that integration is likely to require further crises. On Monday, Spain and Italy delivered another round of uncertainty to markets with their domestic politics threatening to derail economic reforms, which briefly put the euro under pressure. When these events morph into existential threats to the euro, that tends to be the moment policy makers come together and act boldly.
EUR/USD chart
If policy makers can address that weakness, which will be done through Eurozone integration and stimulating the region's economic growth, then the single currencies has a number of strong fundamentals backing it.
The Eurozone has a healthy current account surplus, which rose to €12.6 billion in November from €10.2 billion in October.
Though the ECB has provided tremendous liquidity to the Eurozone's struggling banking system, it has so far sterilized its purchases of Eurozone sovereign bonds – that is mop up the extra liquidity created. It has also suggested that if it's Outright Monetary Transaction program is called upon to support peripheral Eurozone bond markets, which also comes with strict conditions for applicants, it would seek to sterilize those purchases as well.
This looks like a more conservative approach to monetary policy than that practised by the U.S. Federal Reserve, Bank of England and Bank of Japan, which have been deliberately flooding their financial systems through aggressive quantitative easing.
Holders of U.S. dollars are growing concerned over its debasement and are openly talking of finding alternatives. There's also a growing trend for countries to sign bilateral trade deals, which exclude U.S. dollars as the transaction currency. The U.S. dollar is still by far the world's main reserve currency accounting for over 60% of identified reserves, but that's compared with 71% in 2000.
The euro has risen from around 18% of world identified reserves in 1999 when it was launched to about 24% in 2012 making it the number two reserve currency. There has been some movement out of the euro recently by emerging market countries and Switzerland, but that might be more because of short-term technical factors.
Should the Eurozone's authorities manage to sustainably stabilize its internal economic strains, the euro could be set to eventually challenge the U.S. dollar's top spot and play host to the growing number of countries around the world, which are keen to diversify their reserves. It's also noteworthy that the ECB has so far been absent from the currency wars – a way of telling the markets that someone out there still believes in a hard currency? More clues on the ECB's attitude to the strength of the euro could be revealed at its Thursday press conference.
Drifting towards a multi-polar reserve currencies
Though European politicians have been sounding off recently over euro strength, they can't tell the ECB what to do and because of its Bundesbank-inspired mandate, it's actually relatively more independent than many other central banks.
Therefore a good strategy could be to look to go long on EUR/USD or EUR/GBP on political set-backs, particularly as some sort of resolution emerges. The foundations of the euro are gradually being put in place in that the Eurozone is slowly beginning to resemble a state rather than a union.
Going further out forex markets appear to be moving towards a multi-polar world of reserve currencies where the U.S. dollar, euro and eventually the Chinese yuan, if and when China allows it to freely float, will hold similar weightings. Should that trend play out, and there's no guarantee it will, that would potentially represent a bearish influence on the U.S. dollar, but a positive one for the euro and the yuan.
