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Monday August 18, 2008 - 04:15:22 GMT
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The Euro Bubble



The euro has fallen 8.6% in value against the dollar in month, 4.3% in seven trading days. Currency markets are highly speculative and are not usually spoken of as having bubbles.  But what else should we call a market that adjusts at this speed?


The fundamental market view since the credit crisis blew up last August was that the United States economy would be punished by the combined housing, credit and financial crises. This view was responsible for the year long ascent of the euro against the dollar, or if you prefer, the fall of the dollar against all its trading partners.


The US was supposed to collapse, driven to recession by the moribund housing market, job losses and retreating consumer spending; the Eurozone would falter but not fail.  Why else buy the euro? 


Central bank policies on both sides of the Atlantic would flow from this difference in economic outlook. The Fed governors would have to relent on inflation because of the weakness of the US economy; the European Central Bank (ECB) could retain its traditional German adamancy against inflation because resilient Eurozone economies would deflect criticism of its anti- growth bias. This view was not only prevalent in the currency markets but in many ways this was the Fed and ECB view as well.  The potential for reverses in the American economy, in addition to the strains on the financial systems, was the reason Bernanke so quickly and dramatically cut rates.  The moderate but steady Eurozone growth relieved the ECB of the need to support its economy and the ECB actually raised rates 0.25%.


The rate cuts by the Fed were not a rescue for the banks but for the economy on which the banks depend.  No amount of central bank liquidity in whatever form can rescue the financial system if the underlying economy is bankrupt. The asset backed securities market, which created the initial problem, could not stabilize until the housing market stopped falling. If mortgage default rates had continued to rise then the mortgage potion of the asset backed paper which was spread throughout the market became more and more worthless.


 An economy in recession especially a deep recession destroys jobs and the ability to service residential mortgages. In cutting rates the Fed was taking action against the long term scenario that was not evident last August but was a clear threat given the emerging fragility of the financial system. 


If the expectation that the Eurozone GDP would be less affected by US problems was plausible maintaining that idea in the face of skyrocketing oil prices was not.


There is no broader measure of an economy's production than GDP.  Eurozone GDP was negative in the second quarter. Until Mr. Trichet’s admission less than two weeks ago negative EMU growth was not part of the currency market scenario.   Now it is.


The Harmonized Index of Consumer Prices, the EMU wide measure of inflation, dropped 0.1% on an annualized basis in July.  One tenth of a percent is a minor amount. But remember Trichet's comment of several months ago that inflation will be a hill, with a down slope in the future.  The expectation of the ECB planners is that inflation could subside of its own accord if the economy slows and external prices pressures, primarily oil, fade. Is this the beginning of that decline in inflation?  The astronomical rise in oil prices has already reversed.  


The ECB is no Reserve Bank of Australia (RBA). You will not hear from the heirs of the Bundesbank what traders heard from RBA deputy governor Ric Battelino that “Waiting to see a fall in inflation before we start cutting rates would be too late.” But it is true for the ECB as well as the RBA. Second quarter GDP is proof.  The ECB needs to change its rate policy.  It cannot wait for the return of 2.0% target inflation before it acts. Unfortunately its credibility also needs a discrete interval before it can move to a rate reduction bias.


Facts are stubborn things.  American second quarter GDP was 1.9% and will likely rise to 2.5% because exports were stronger than estimated for the original number. Eurozone GDP was -0.2%.  These are not facts that support a euro north of 1.5000.  The decoupling fantasy has been firmly debunked. Why did it ever become current?  Why was oil at 147.00?  For the same reason -- the traders, whose cumulative decisions those prices represented made more money long than short. It seems simplistic. But markets use facts as reference points not absolute measuring devices.  Rising demand in the oil markets does not predicate a specific price; it means traders would rather bet long than short.  When the bet is worn-out, when it is undermined by facts, the market shift is like an avalanche.


The fall in the dollar and the rise in oil prices were not unrelated. The weak dollar did not cause oil to strengthen but it added to an oil trader’s disposition to buy futures. The dollar did not rise because of the fall in oil prices; in fact oil started falling well before the dollar began its spectacular ascent.  But the collapse in oil prices did help convince currency traders that the weak US/strong Eurozone scenario was without foundation. Sometimes a clear fact can destroy months of unclear speculation. Eurozone GDP was the immediate cause of the euro decline, but the signs had been gathering for months.


Now that the underlying view of the market has changed what is the future of the euro?  Mr. Trichet’s warning may well come to pass, we may see at least two quarters of negative growth in the Eurozone. If US growth remains moderate, above 1.0%, then the euro will suffer by comparison. What portion of the US second quarter GDP was supported by Federal stimulus checks is hard to tell. But as long as the US remains positive and the EMU does not, the euro will fall.


If American economic growth becomes negative in the last half of the year, the euro will not recover.   If both the US and Europe are in recession in quarters three and four the benefit of the doubt will have to go to the US for a quicker recovery.  In addition to its structural advantages of flexible labor markets and lighter regulation the US has a growth responsive central bank and the Eurozone does not.  Which policy is correct is not the question. But which policy will produce a faster return to economic growth is one of those stubborn facts that cannot be ignored. US growth prospects are better than the Eurozone. And the prospects for the dollar will continue to improve until that changes.


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