Whose Problem is the Euro?

President Nixon, or somebody in his administration, allegedly told the Europeans that “the dollar is our currency, but your problem”. Could we say something similar of the euro nowadays?

There is lot of hype around the euro since the Greek sovereign crisis has started. We are being told that its recent decrease in value is as serious problem for European countries and a signal of the breakdown of the European Union.

The euro has been above 1.40 (versus the US $) from summer 2009 till more or less January 2010, when it started a gradual descent towards 1.3. Over the last couple of weeks this has accelerated, and it is now below 1.25.

This is a decrease of ~12 per cent: considerable, if not exactly a rout.

The sovereign credit crisis in southern Europe has been driving the descent since last December / January, when fears about Greece started. They were originally kept in check by soothing statements of German politicians. Later revelations of inaccurate accounting on Greece’s part rekindled the crisis, till the recent fever pitch, when finally even Italian government bonds were heavily sold: the euro dutifully increased its rate of descent.

At this point, European governments took action, and announced the by now famous 750 billion EUR package of support for all those who might need it. Additionally, and probably more importantly, European central banks ate their recent words and started Quantitative Easing, entering the markets to buy sovereign bonds (and maybe corporate as well).

These announcements had a dramatic impact on bonds, with Greek, and other, yields plummeting on the Monday following the agreement. As the bonds rallied, equity markets joined in the frenzy and skyrocketed.

What about the euro? It originally rallied in sympathy, but ended the week at its lowest since Lehman’s collapse. This has been attributed to the market fearing the break-up of the euro, linked to rumours of Mr. Sarkozy allegedly threatening to leave the currency union, and an overall lack of confidence in the fiscal situation of European governments.

Several commentators, having welcomed the bailout package, are now also calling for more drastic action, including severe fiscal retrenching and austerity measures. It seems that the decrease in value of the euro is some kind of tragedy. Or is it?

This all smacks of panic, both in the markets and in the press. First of all, the rally in bonds means that the market is not so worried about the sovereign credit quality, at least not on the short term timescale which determine prices: do not forget that markets are made of human operators, often in their early twenties, with a very limited time horizon for their trading and investment. Certainly they could fall again: the main feature of markets at the moment is volatility and panic, not rational analysis. But if they do, it could also be because of more positive economic news, and hence expectation of rate increases: which would be driving the euro back up.

In fact it is likely that the euro continued decrease is caused by the realization that low rates in Europe are virtually guaranteed for the foreseeable future, which means that the euro is probably now at the centre of the forex “carry trade”, taking the role held for years by the yen, and recently by the US $.

Why are rates expected to remain low? The economy is stuttering, showing fewer sign of recovery than the US. Austerity measures are a near certainty, given the high debt and deficit of many states: this will hit the economy even harder. So the European Central Bank will not raise rates, and is additionally pumping liquidity via QE. If this is the case, bonds will remain reasonably strong, and the main asset class to suffer will probably be equities.

Let me conclude remarking that a weak euro is very good news for countries in the eurozone. It will make their exports more competitive, decrease the value of the debt, and at least partially counter the deflationary trends.

So, despite any rhetoric from central bankers and politicians, do not expect any concrete action to strengthen it. Unless, of course, there is pressure from the US and China.

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