This post will discuss how revived regional political tensions have provoked the reemergence of the sovereign debt crisis, accelerating the timeline for significant Euro weakness from the 2H’13 into the end of the 1Q’13. We also explain why any calmness in markets will be as a result of the European Central Bank, and nothing more.
As we said in the first post in this series, coming into 2013, peripheral European sovereign yields remained low and relatively compressed to their German equivalents, allowing the Euro to outperform every major currency into February 1. But the journey from $1.2041 versus the U.S. Dollar on July 24 to $1.3710 on February 1 was not an easy one; at many points it appeared like the European Central Bank-induced rally was going to fall apart. This go-around, it may be time.
With each tumble in the EURUSD in 4Q’12, there was an ensuing rally. But why not; the Federal Reserve had begun its QE3 program and the political situations from Greece to Spain were much calmer than they had been back in July. Yet everyone was very aware that the economics of the region (discussed last post) were remaining quite sour and in most cases, getting worse. Clearly, just as was the case with the rally in the S&P 500, there are other forces in play here driving confidence in the Euro, because a regional growth rate at its weakest point in the past five years is no reason to be bullish.
In order to buy governments time and bring down sovereign borrowing costs, ECB President Mario Draghi fulfilled his late-July pledge to do “whatever it takes” to save the Euro by pledging a liquidity program known as the OMTs, or Outright Monetary Transactions, which would effectively place a ceiling over Italian and Spanish yields for an unlimited amount of time, so long as budget consolidation was taking place.
Initially, similar to the impact that the Federal Reserve’s QE has had on the U.S. Dollar, the expanding ECB balance sheet size in early-2012 led to a sharp depreciation in the value of the Euro. But with bond yields tethered down and no additional liquidity injections required, the ECB was able to reverse the its balance sheet expansion by late-2012, and reduce its size in the beginning of 2013. While this initially led Euro strength over the past several months, sufficient evidence has gathered that the crisis may have been stirred.
The Italian elections that took place at the end of February emphasized how fragile the overall situation is in Europe: voters are becoming angry with their leaders, feeling as if supranational or even international powers are dictating policy. This is fitting, given the governments present in Greece, [especially] Italy, and Spain presently. Pandora’s Box has now been opened: 55% of the Italian electorate voted for the anti-austerity candidates, meaning that the Italian economic picture could worsen dramatically quickly once more, if investors lose faith in the bond market.
Greece and Spain are no “picnics” either. The Greek government remains highly unpopular and will likely head back to elections once German Chancellor Angela Merkel retains her chancellorship in the September German elections, while the Spanish government faces corruption charges and still puts off the necessary budget reforms desired by the core Euro-zone countries. We find there little reason to be bullish on the Euro, given the significant backdrop of European growth and political concerns, and wouldn’t be surprised in the slightest to see the EURUSD trade under 1.3000 for a sustained time (>3 months) in 2013.
This series of eight posts will focus on the major themes affecting currency markets. The eighth and last post in this series will review Chinese growth, performance of base metals, and forecasts for the Australian and New Zealand Dollars for 2013.