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Forex Blog - The Problem with the EuroThe Problem with the Euro
May 30, 2008The Problem with the EuroSwapping out CommoditiesThe Euro at Par with the DollarLaguna Beach, Montreal and Las Vegas
Last week I wrote that we could see a drop in the price of oil as
speculators seemed to be storing oil in very large tankers and "slow
steaming" them to port in a bet that prices would rise. When everyone
is on the same side of the trade, the time is right for a reversal.
This is especially true when there is a large potential supply sitting
on the sidelines.
This week we briefly look at this prediction,
and perhaps even more ominous problems for commodities in general, at
least in the short run. The new turn our attention to the euro. It will
make for an interesting letter.
First off, oil dropped about 4%
yesterday and is down almost $10 from its high only a week ago. Yet
supplies of crude oil surprisingly dropped by 8.8 million barrels
yesterday. Oil shot up on the news as both those who were short covered
their bets and even more people piled into the long side of the trade.
then the EIA report gave the rest of the story. It seems the shortfall
"was due to temporary delays in crude oil tanker off-loadings on the
Gulf Coast." And as Dennis Gartman noted this morning, "officials at
the Louisiana Offshore Oil Port (LOOP) said
that some crude oil
tankers cancelled scheduled deliveries last week." The owners of the
oil in those tankers are now down about 6-7%, whether it is speculators
in the pits or the actual trading companies.
I talked with
George Friedman of Stratfor this morning, and he says that the supply
of tankers is even tighter, which suggests there is even more oil on
the seas looking for a home. Crude oil prices could be under pressure
in the next few weeks and months as whoever holds that oil is going to
want to get it onshore somewhere and out of very expensive tankers.
Swapping out Commodities
Commodity Futures Trading Commission announced yesterday that they are
looking very hard at possibly closing a regulatory loophole that
allowed some extremely large commodity index funds to get around
position limits. For those not familiar with the concept of limits, it
basically works like this. No trader or fund is allowed to own more
than a specific amount of a commodity traded on the futures exchange.
This limit varies from commodity to commodity and exchange to exchange.
The point is to keep one group from manipulating the price of a
commodity, as the Hunts did with silver in the early 80s.
loophole is one where large investment banks can sell a "swap" for a
specific commodity like corn and then hedge their position in the
futures markets. There is no limit on the amount of the commodity that
can be hedged. So, a fund can accumulate sizeable positions far in
excess of what they could do directly by working with an investment
bank. In essence, the swap is a derivative issued by a bank which acts
just like a futures trade, but it is with the bank as guarantor and not
an exchange. Swaps are not regulated as such. And up until now, the
banks were seen as legitimate hedgers so there were no limits on what
they could buy in the futures markets.
This works for very large
commodity index funds which try to mirror a particular commodity index
and need to be able to buy very large positions in excess of the normal
limits (and there are scores of them), and for the banks that make the
commissions and profits on the swaps. Remember, the fund gets a
management fee, so growing the size of the fund grows their fees.
indexes typically have about 26 commodities, with the largest
allocation to oil, but almost anything that is traded has some small
portion of the allocation. As I noted last week, there are some who
believe this is working to drive up the price of commodities beyond the
simply supply and demand principles. Whether or not you believe this to
be the case, the CFTC is looking at the loophole.
The key word in
the announcement yesterday was the word "classification." Right now the
banks are classified as hedgers and as such have no limits. But they
are not really hedging the actual physical commodity as a farmer or
General Mills might do, but the hedge is their financial position.
the CFTC decides to look through them to the funds, and they did use
the word transparency in their announcement, they could decide to
change the classification of the banks from hedgers to speculators.
While I do no think that might make a difference in the long run, in
the short run it could make commodities volatile in the extreme, and
exert downward pressure up and down the price curve, depending on how
they would decide to unwind the commodity index funds.
its worth, I advised my daughter to get out of the commodity fund she
was in for the time being. When the regulators are in the room,
anything could happen. And they are getting intense pressure from
Congress to change the rules. My bet is that the train has left the
station and it is but a matter of time until position limits are put in
place for commodity funds, including commodity ETFs. Is that a good
thing? I think not, but that matters not one whit. The hand writing is
on he wall.
Does this mean I am not a long term commodity bull?
No, I remain bullish on a host of commodities over the long term from a
supply and demand perspective. It is just that you might want to
consider whether to stand aside for a time while the congressional
elephant is stampeding around the room. Maybe it is a non-event and
someone figures out a way to unwind the positions slowly and over time.
Maybe the grandfather the current funds at the size they are today. Who
knows? As I said, when the regulators are under pressure to do
something, I want to know what the new rules will be before I play in
The Euro at Par with the Dollar
five years ago, I said that the euro, which was trading at about $.88
at the time would rise to $1.50 and then fall back to $1 over the
course of a decade or more. It would be one huge round trip. By the
way, giving credit where credit is due, that opinion was crystallized
over a long dinner with bond expert Lord Alex Bridport and several
companions in Geneva. The logic was compelling then and it still is
now. We are halfway through that decade long trip and it remains to be
seen if we get back to parity. I think we will.
Why would the
euro fall? Because the currency is still an experiment in cooperation.
At some point, one or more of the weaker European countries is going to
need more monetary stimulation than the majority of the countries in
the union, for a variety of reasons. Will they pull out to be able to
issue their own fiat currency? Will the EU as a whole slow down as the
About 4 times a year, I give myself permission to
not write a letter, taking a little mental vacation. This week, Louis
Gave is graciously allowing me to use a chapter from his latest book,
"A Roadmap for Troubled Times" which highlights some of the problems
the euro is going to face, as well as analysis on a host of topics.
reader, this is an important topic and Louis says it better than I can.
I highly recommend you get the book and read it. It is only about 200
pages and is a very easy read. The chapters on China are worth the
price of admission, as well as his suggested investment themes. You can
order the book at Amazon.com.
So, without further ado, let's jump into the problem with the Euro.
The Change In Policy
The Divergence in European Spreads - Why Now?
Back in May 2007, we wrote a piece entitled "Part 2-So What Should We Worry About". In that ad hoc comment, we wrote: "The
crux of the thesis of our latest book, The End is Not Nigh, is simple
and goes something like this: a) Asian central banks continue to
manipulate their currencies and prevent them from finding a fair value
against either the US$ or the Euro b) this manipulation triggers an
accumulation in central bank reserves which, in turn, leads to low real
rates around the world c) the combination of low global real rates and
low Asian exchange rates amounts to a subsidy for Asian production and
Western consumption d) in the US, the subsidy has by and large been
captured by individual consumers e) meanwhile, in Europe, the subsidy
has been cashed in by governments whose debt has skyrocketed f) we see
little reason why, in the near future, the subsidy should be removed
but g) if it were removed, the US would most likely encounter a
consumer recession (not the end of the world) while h) Europe could go
through a debt crisis (far more problematic)."
We went on and wrote: "Last
week, and against most observers' expectations, the Indian central bank
did not raise rates at its meeting. Instead, it seems that the
authorities are allowing the currency to rise and hopefully thereby
absorb some of the country's inflationary pressures (linked to energy
and higher food prices). In recent weeks, the rupee has shot higher and
now stands at a post-Asian crisis high. And interestingly, the local
market is loving it. While Indian stocks had been sucking wind year to
date, the central bank's apparent policy shift (from higher interest
rates to higher exchange rates) has triggered a very sharp rally.
of course is an interesting turn of events and we would not be
surprised if Asian central banks were to study developments in India
carefully over the coming quarters. After all, India is blazing a path
that a number of Asian countries may yet decide to follow.
could argue that a change in monetary policy in Asia could end up being
a "triple whammy" for Western economies. It would mean that:
central banks would export less capital into our bond markets and this
would likely lead to a drift higher in real rates around the world.
- Asian exchange rates would move sharply higher, which in turn would likely mean higher import prices in the US and Europe.
Asian exchange rates start to move higher, Asia's private savers would
likely start repatriating capital, further amplifying exchange rate and
interest rate movements. This would also likely lead to collapses in
monetary aggregates in the Europe and the US.
Finally, we concluded the paper by saying: As
we highlighted in Part 1: Why We Remain Bullish, we are not worried
about valuations. And we are also not worried about "excess leverage"
in the system, or the threat of a "private equity bubble". We also do
not fear an "economic meltdown" or a brutal end to the "Yen
carry-trade" (which we did fear in the Spring of 2006). Instead, if we
had to have one concern, it would have to be a possible change of
monetary policy across Asia and the impact that this would have on real
rates around the world. As we view things, the only reason Asian
central banks would change their policies is if food prices continued
to increase (in that respect, owning some soft commodities -- a hedge
against rising real rates -- makes sense to us - as does owning Asian
currencies). Interestingly, such a turn of events seems to be unfolding
in India, yet no one seems to care. Monitoring changes in Asian
inflation, monetary policies and exchange rates could prove more
important than ever.
Nine months after that paper, we have
indeed just gone through a period of a) rapidly rising food prices
which have led to b) faster inflation rates across Asia, which have
triggered c) a change in Asian monetary policy, notably a willingness
to let the currencies appreciate faster than they have in the past. And
if Asian central banks are now finally allowing their currencies to
rise, then one thing is sure: Asian central banks will no longer need
to print large amounts of their own currencies and accumulate US$ and
Euros. They will thus also no longer need to buy US Treasuries and
European bonds to the extent that they have.
Is it a co-incidence
that, as Asia starts to allow its currencies to rise, US mortgages have
been hitting the wall and spreads amongst European sovereigns have
started to widen? The subsidy that Asian central banks have been giving
to consumption in the US and governments in Europe (see The End is Not Nigh) is now disappearing.
for the past five years, spreads of Italian ten-year government bonds
to German bonds have hovered between 15bp and 25bp. But recently,
spreads have started to break out on the upside.
of course, Italy is not alone. All across Europe, we have seen a
widening of spreads between the "stronger" signatures (Germany,
Holland, Austria, Finland, Ireland) and the "weaker" signatures
(Portugal, Italy, Greece, Spain, Belgium, France) including those of
Eastern Europe (Latvia, Romania, Hungary, Poland...).
Now as our more seasoned GaveKal reader will undeniably remember (see Divorce, Italian Style, or The End is Not Nigh),
we have argued that spreads between Europe's sovereigns were set to
widen for the past few years. And yet, nothing happened. Until, that
is, we started to see Asian central banks allowing their currencies to
start appreciating faster.
But what happens if Asian central
banks now stop buying up European government debt to the tune of recent
years? For a start, European money supply growth should decelerate
rapidly and with it, economic activity. A bigger problem will then be
the ability of European governments to raise further financing. Indeed,
as economic activity tanks in Europe, and the Euro starts to fall, it
is likely that investors will all of a sudden realize that governments
only go bust when they issue debt in a currency that they cannot print.
In the past fifteen years, France government debt to GDP has
moved from 35% in French Franc (i.e.: a currency the government could
print at will) to 70% in Euros (i.e.: a currency that only the ECB can
print). No wonder that Francois Fillon, the current French Prime
Minister recently declared: "I run a state which now stands in a
situation of financial bankruptcy, which has known deteriorating
deficits for fifteen straight years and which has not voted a balanced
budget for twenty-five years. This cannot last."
importantly, the tightening-up of Europe's financial situation, and the
widening of spreads between the "good borrowers" such as Austria,
Finland or Germany and the "poorer borrowers" such as Italy, Greece, or
Portugal, could have a devastating impact on Europe's commercial banks.
Consider this piece of news from January 2008: "Landesbank
Baden-Wuerttemberg, Germany's biggest state-owned bank, said 2007
profit will be about 300 million euros ($438.9 million) because of a
drop in prices of banking and government securities. LBBW said it
doesn't expect any defaults since the securities concerned have good
Less profits because of a drop in government
securities? The careful reader may be somewhat surprised by this
statement; after all, everywhere one cares to look across the OECD,
government bond yields are close to their 2003 lows. So how did
Germany's biggest state-owned bank manage to lose money on government
securities? The answer, we believe finds its source in the funky
regulations of Basel II. According to Basel II, an OECD country bank
can sell a credit default swap on an OECD sovereign and this CDS:
- Does not have to be marked to market (since it is assumed that an OECD country will not default on its debt).
not require the selling bank to put aside any capital on its balance
sheet (since, once again, it is assumed that the country on which the
CDS is written will not default).
In other words, for the
past few years, clerks all over Europe's banks and insurance companies
have boosted the bottom line with the "free money" that the sale of CDS
provided. Every now and then, a clerk at the Treasury department of ABC
Landesbanken would call up Goldman Sachs or Deutsche Bank and say: "I
want to sell US$ 1bn of protection on Italy at 15bp for five years".
And for five years, ABC Landesbanken would receive US$1.5 million
without having to set aside capital on its balance sheet or take a
"mark to market" risk on its income statement. Or so it thought...
Indeed, as the spreads between Italy and Germany start to widen something unexpected happens (a
CDS will tend to reflect the spread between the issuer's debt and risk
free debt of the same maturity. Otherwise an arbitrage could be made.
If Italy's debt traded at 100bp over Germany and a CDS on Italy only
cost 20bp, one could buy the Italian bond and buy the CDS and capture a
"free" 80bp): ABC Landesbanken receives a margin call from Goldman
Sachs and Deutsche Bank and, all of a sudden, what was a "risk and
capital free" trade turns out to impact liquidity. Needless to say,
this is the situation we are now in and this probably contributes
further to the widening of spreads. All of a sudden, Europe's
commercial banks are no longer keen to sell the spread as they have
been for the past decade... in fact, they are most likely
trying to buy back some of the contracts they wrote before they move
too far against them.
In other words, a widening of spreads
represents the worst of both worlds for European banks. For a start, it
puts their balance sheets under pressure. For seconds, it cuts down
their income as the writing of CDS on Europe's weaker sovereigns slows
to a crawl.
For Europe's policy-makers, the widening of spreads
poses a serious challenge which, if left unchecked, could cut to the
very credibility of the Euro and the European construction exercise. It
could also trigger a negative spiral such as the one we saw in the US
whereby as the cost of borrowing increases on the weakest signatures,
rolling over debt becomes more problematic, hereby inviting higher
spreads etc... So how will Europe's politicians respond to
this new challenge?
The widening of credit spreads across Europe
reflects an economic reality. It makes no sense that say, Belgium and
Ireland should borrow at the same rate.
Euro 100bn question for investors should thus now be whether a) the
recent widening is a one-off event and spreads are set to soon tighten
again or b) the recent widening is the beginning of a more
fundamentally-based re-pricing of risk across Euroland. The quandary
now is whether politics can get us out!
In the mid 1990s,
Europe's leaders got together and, in essence, said: "wouldn't it be
great if we all got to borrow at the same rate as Germany?" And
everyone around the table agreed that this would be a good thing. The
decision was thus taken to a) create a currency which would resemble
the DM, b) that this currency would be managed by a central bank with a
mandate very similar to the Bundesbank's and c) that countries around
the Euroland would strive to harmonize their fiscal policies
(Maastricht Treaty rules and Stability and Growth Pact) to ensure the
long term survival of the Euro. At the time it was also envisaged that
the collapse in interest rates in certain countries (Italy, Belgium,
Spain...) would give a tailwind to growth which would allow governments
around the more indebted EMU countries to tighten their belts and clean
up their fiscal houses.
The collapse in interest rates happened,
as yields converged to the German rate... but unfortunately, the
clean-up in fiscal houses did not. In fact some countries like France
cashed in the "growth dividend" and voted themselves greater benefits
such as the 35-hour work week.
brings us to today and the recent widening of spreads across Europe.
This widening is a sign that the market is starting to acknowledge that
the promises have not been kept. . But of course, the main problem with
that solution is that it implies that Europe's governments will have to
tighten their belts over the coming quarters, i.e.: at the worst
possible time in the cycle. After all, it is always hard for a
government to pull back and shrink its size of the GDP cake... but in
an economic slowdown, it is close to impossible.
It is all the
harder to do when there is little political will for far-reaching
reforms. As a former German central banker once told us: "I use to
think that France needed a Margaret Thatcher, I now realize she needs
an Arthur Scargill" (Scargill was the Trotskyite leader of the Miner's Strike).
In other words, to get a government to shrink its size, you first need
a serious crisis (or a scarecrow a la Scargill); only then do people
accept real sacrifices.
And we should make no mistake about it:
reforming Europe's welfare states will take real sacrifices. Take
pensions as an example: for years, most European countries have run a
pay-as-you-go system whereby people of my generation will pay directly
for the retirement benefits of my dad's generation (actually, this sounds like what I do at GaveKal every day). In
other words, Europe's pension systems are usually massive pyramid
schemes; they work as long as the base grows and ever more people
contribute to the bottom of the pyramid. The problem, of course, is
that in a growing number of European countries, the base is no longer
such, the off-balance sheet liabilities assumed by the government in
matters of pensions which, until recently, had always been
self-funding, are now set to come back on the governments' balance
sheets. Now the last time Europe ran a comprehensive survey of pension
liabilities was in 2003... and the data back then was scary. We guess
the situation does not look any better today.
deteriorating demographic and pension situation alone means that
Europe's governments do need to contemplate serious pension reform. Or,
failing that, to open their borders to workers from all horizons in
order to keep expanding the tax-paying, pension- contributing
workforce. Needless to say, neither of these options is very enticing
politically. As such, rather than convince millions of pensioners to
cut their benefits, or work longer, Europe's politicians may be tempted
to try and convince a small minority of central bankers sitting in
Frankfurt to massively ease monetary policy and print a bunch of money
to help the governments meet their liabilities.
In essence, the
scenario we are painting is a simple one: the credit crunch which has
thus far mostly only engulfed the US is starting to make its way into
Europe. And soon enough, Europe's banks will likely be reporting losses
and write-downs, and investors will flee to the safety of the highest
government bond paper. Unfortunately for Italy, Greece, Belgium or
Portugal, their paper does not qualify as "high quality".
we highlighted earlier in this book, a credit crunch typically invites
a "three-step" plan policy response. First, one collapses the currency
(to make one's assets and goods more attractive to foreign capital and
invite inward capital flows). Secondly, one needs to see the banks
recapitalized (if the market can not do it, then the banks need to be
nationalized). Thirdly, one puts in place a very steep yield curve in
order to force the banks to start lending again and the private sector
to take risk.
It is obvious today that this course of action is
very much the preferred path of, for example, President Sarkozy. Hardly
a day goes by without the French President taking the ECB to task for
doing so little to help Europe's liquidity crunch. But each time he
does, his comments are increasingly met by responses from Angela
Merkel, the German Chancellor, for whom the independence of the ECB is
The possibility of a massive easing from the ECB is
nonetheless an interesting one and raises the question of how the
market will respond to a more activist ECB. Would an ECB that did the
bidding of politicians be seen as less of a Bundesbank and more of a
Bank of Italy/Banque de France? And if so, would long bond yields
across Europe be below 4% and the Euro at 1.55/US$? Would the foreign
central banks that have been piling into European government paper
remain keen to finance Europe's welfare states?
question, of course, is what would happen in the event of a bank
bankruptcy in Europe? Would the ECB bail out the failing bank? Would
the government of a failing bank be allowed to bend the EU's
competition rules and nationalize the troubled financial institution?
These are all questions with answers that remain unclear.
course, there is another way to go about dealing with a credit crunch:
bitter infighting. This is what Japan did throughout the 1990s when the
MoF would tell the BoJ that massive monetary easing was needed, only
for the BoJ to turn around and say that the MoF needed to stop
financing the construction of bridges that went from nowhere to
nowhere. And as the infighting ensued, the Japanese banking system
wrote off its entire capital base not once, but twice, over the course
of the decade. Meanwhile investors shied away from all asset classes
save the highest quality government bonds.
Could the same thing
unfold in Europe? In Japan, there were only three sets of players (the
BoJ, the MoF and the LDP) and over fifteen years, they could not seem
to get the three-step plan (currency devaluation, bank recap, steep
yield curve) right. In that regards, when considering the numbers of
players involved in Europe, one may fear that the same policy paralysis
could easily grip Europe. And, in this case, the recent break-out in
the spreads that has now started will prove to have marked the start of
a revolutionary trend for our financial markets: the end of the
convergence trades and the start of the divergence trades.
A few years before his death, Professor Milton Friedman declared: "It
seems to me that Europe, especially with the addition of more
countries, is becoming ever-more susceptible to any asymmetric shock.
Sooner or later, when the global economy hits a real bump, Europe's
internal contradictions will tear it apart." Today, one should
question whether the "real bump" is being hit and whether Milton
Friedman will end up being proven right. But regardless of where one
falls on the answers to these questions, one thing is sure: selling the
bonds of Europe's weakest signatures and buying protection on Europe's
weaker banks continues to make sense. It is some of the cheapest
protection available against what remains a massive "fat- tail" risk to
our financial systems. That's why we love this trade so much: the
potential rewards are huge and the upfront costs still marginal. More
importantly, it is a very good hedge against what would be a nightmare
scenario for many financial institutions.
A Final Thought
the next chapter of A Roadmap for Troubled Times, Louis goes into
detail into how Italy might be the country to push the European Central
Bank to take steps it might not otherwise want to take. Again, I strongly suggest you get the book. It is very thought-provoking and one of the better reads that I have had this year.
Laguna Beach, Montreal and Las Vegas
leave with my daughter and partner Tiffani to fly to Laguna Beach in
about an hour to be with Rob Arnott at his annual Research Affiliates
Symposium and party. Rob arranges for some of the brighter economic
minds in the country to give presentations. Harry Markowitz, Burton
Malkiel, Peter Bernstein, Paul McCulley and Jack Treynor, among others.
On Saturday evening, my good friends Vernor Vinge and David Brin, who
have both won every award you can win in Science Fiction several times
over, as well as being in the science Fiction Hall of Fame, will regale
us with their views of what the future will look like. I get to
moderate that event, and I am looking forward to it.
I fly to
Montreal in a few weeks to speak for a conference put on by Canaccord
and will get to have dinner with Martin Barnes and Pierre Casgrain. And
then I will fly to Las Vegas July 10-12 for the annual Freedom Fest
Conference where I will speak several times, but the line-up of
speakers is as strong as any conference I have been to.
Denish D'Souza will debate Christopher Hitchens, Steve Forbes, Ron
Paul, Stephen Moore (Wall Street Journal) Charles Murray, George
Gilder, John Goodman and about 100 other speakers, each impressive in
their own right, will be there as will 1,000 freedom loving
attendees. You can go to www.freedomfest.com
and click on the list of speakers and register. Mark Skousen is the
driving force behind the conference, and he does it right. I hope to
see you there.
This will be a good weekend, as the food is always
great and the intellectual stimulation is better. But the best part is
being with friends and enjoying it together. Have a great week.
Your having more fun than ever analyst,
Copyright 2008 John Mauldin. All Rights Reserved
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Forex news reports can be found on the forex research
headlines page below. Here you will find real-time forex market news reports
provided by respected contributors of currency trading information. Daily forex
market news, weekly forex research and monthly forex news features can be found
Real-time forex market news reports and features providing
other currency trading information can be accessed by clicking on any of the
headlines below. At the top of the forex blog page you will find the latest
forex trading information. Scroll down the page if you are looking for less
recent currency trading information. Scroll to the bottom of fx blog headlines
and click on the link for past reports on forex. Currency world news reports
from previous years can be found on the left sidebar under "FX Archives."