Sunday, December 20, 2009

Technical Update 49.09/European Woes

Another week of gains for the US dollar was met with general indifference from equities around the world. Commodities also turned their cheeks to the currency market action, reminding us that correlations long-adhered to can break. Last week we were expecting a bit of a retrace in the dollar index and commodities which would allow for equities to put in new highs. That is still my working assumption. Yet with option expiry hangover, combined with 2 weeks of very low volume upcoming, I suppose anything is possible.

The weakness in the Euro is being blamed on sovereign concerns around the periphery of the EMU (European Monetary Union). Specifically, Greece, Ireland, Spain, Portugal, and Italy are the focus of most observers. But bear in mind that these issues are not somehow "unforeseen" as most imply with their surprise. Greece did not accumulate a 12.4% budget deficit overnight. Nor did Italy find itself with a total debt 1.14x its GDP. These have been very long-term problems. I, as well as many others, have been pounding the table with the untenability of this situation for a long time. And I ruminated back in the spring that the next round of this crisis would originate in Europe.

Social mood may have turned with the recent attention to these long-standing problems. And we know the kind of contagion that will result should this escalate. Let us not forget the issues facing Ukraine, Hungary, Romania and the Baltics. All major european financial institutions have exposure to these toxic emerging markets in addition to their hidden exposure to US subprime CDOs.

Below is a table from STRATFOR that details each Eurozone country and their debt burdens. Remember that the Maastricht Treaty forbids any country from surpassing a deficit of 3% of their GDP. Nearly every nation has completely ignored this. Germany's supposed new "conservative" coalition threw in the towel this week, suggesting they would escalate their deficit spending. If nothing else, this proves the uselessness of international regulations. When push comes to shove, any nation will look after their own asses first. It is this mentality that will, in my opinion, eventually lead to the breakup of the EU and the dissolution of the EMU. This process may have begun already. Or it may be dragged on for a decade or more longer. But the endgame is already written. A Euro will eventually be worth less than the "lowly" US dollar.

I recommend readers monitor CDS spreads closely as an indicator of the seriousness of these problems. Over a week ago, when stories started breaking about Greece's problems after a Fitch downgrade, their CDS premiums shot up to 232. Since then, Greek officials have said there is "no possibility" of EMU withdrawal or sovereign default. Yet, the assurances have not seemed to gain traction. Greek CDS now stand at 279. Intraday top movers in CDS premiums can be found at CMA Market Data.

Below is a chart of the Euro's performance. This makes 3 weeks straight of declines and essentially wipes out any of its gains from the previous 3 months. What's done can be undone in short order. Equity speculators should take note.

I am also including a number of charts from eastern European currencies relative to the Euro. Last winter, some of these currencies began blowing out. But assurances from the IMF managed to ease the fears - for a time. At issue are loans made in these countries (Latvia, Poland, Czech Republic, Hungary, Bulgaria, Romania, Ukraine, Russia) but denominated in other currencies (primarily the Euro, Swiss Franc and US Dollar). The availability of loans at very low interest rates; prospects of continuance in the decade long appreciation of local currencies; and eventual induction into the EMU were the primary forces driving asset bubbles in these countries. When the bubbles popped along with asset bubbles all over the world in 2008, their central banks began printing money to "stimulate" their economies. This had the effect of depreciating the local currencies and thus increasing the debt burdens of those who borrowed in foreign currencies. Default prospects increased, jeopardizing the solvency of their western lenders. This is where the IMF stepped in and gave some very vague guarantees with some very unknown preconditions. Most likely they instructed the eastern central banks to stop printing and told their finance ministries to instead introduce austerity measures. I wonder how long populist oppositions will stand for the rising unemployment that goes along with this? At what point will they simply say, "to hell with the western bank's losses, we default." Or, "to hell with the EU and the Euro, we're inflating our way out!" Either way, losses will eventually be realized on these malinvestments.

Hungarian Forint/Euro:

Polish Zloty/Euro:

Russian Ruble/Euro:

Ukrainian Hryvnia/Euro:

There are also potential issues in Bulgaria and Latvia, where currencies are pegged to the Euro. They were both scheduled to enter the EMU by 2012, but that now seems unlikely. If they decide to forego entrance, their pegs break and any loans made are essentially wiped out.

Ambrose Evans-Pritchard has another Euro-skeptic piece detailing the unsustainable nature of these austerity measures in southern Europe. Enduring deflation is the natural way out of things for the US, UK, Canada and essentially any country whose debts are largely domestically originated. But when this path is dictated by foreigners who got you into the problem in the first place, I can see how the political impossibility would lead to its failure.

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d said...

Not sure what you mean by domestially originated.

US debt is held by outsiders.

Japan's debt is held by the Japanese.

Matt Stiles said...

"domestically originated"

I'm including private debts, which in many places are incurred cross-border.

eg. Mexican businesses who borrow in the US, bring the money back to Mexico, suppressing the US dollar in the process and supporting the peso.

Namke von Federlein said...

Hi Matt;

Just a thought. Perhaps much of this revolves around the issue of having a currency that is used both for national transactions and international transactions?

In other words - if you use the same currency for both then a country does not have the flexibility needed for managing their money (example : the STRATFOR table in your blog post).

What if?

What if the Euro was just used by business for cross-border transactions and as a (I'll invent a term here...) "currency of mediation" between various national currencies in the EU ?

My experience in Europe (including the days before the Euro was invented) tells me that the Euro is very handy for doing business in Europe and with Europe.

In other words, what if the Euro was just used as the currency between businesses and governments? No private citizens allowed. If you want to convert a DM into a Franc it would go : DM to Euro to Franc (no direct conversions).

I personally think this will be the end result. National currencies have different needs than international currencies. It isn't "one size fits all".

I also think that China will have the same problem if they try to use the Yuan as both a national currency and a regional reserve currency (imitating the Fed's "take over the world with printed paper promises" strategy which is failing miserably now).

Same for the GCC and oil pricing.

Same for South America.

I think it is time for international businesses and governments to have their own regional currencies - independent of the politics (and various money printing scams) of nation states.

The IMF as a "world currency" would just be repeating the same mistake as the Euro. Regions need their own business currencies. The IMF's job IMHO is to provide a properly collateralized "currency of mediation" between the properly collateralized regional "currencies of mediation" (like the Euro and the Gulfo).

Just some thoughts.

Matt Stiles said...


If I understand correctly, something along those lines are what Mark Carney was advocating in a recent paper "a new way forward."

I personally am skeptical of the idea. I don't think currencies should be "created" by legislative fiat. I'd prefer to see the market determine such matters spontaneously. But for all I know, the market could come up with something like that.


Steven said...

I'm surprised to see the gold price continuing to fall. I expected support near the $1,100 area to hold, but clearly it hasn't. And it looks like some big investors are betting on further price declines, at least based on options activity on the XAU index, which I saw mentioned here:

Matt Stiles said...


I'm watching the November close as the support level on Gold (around 1041 spot). If we close December below that, it puts in a bearish reversal month, which is typically a slam dunk technical pattern on commodities.

But then again, after 4-5 years of calling the gold market with about as much ease as a cricket match, it has frustrated me over the past 6-8 months. I'm definitely not a hot hand in PMs right now...

mannfm11 said...

Matt, as always you raise good points. There is one thing missed about currencies that I believe to be the truth. Though they are national in nature, I believe them to be bank paper and not so much government paper. The Euro is a classic case and it is probably why the Englizh didn't fall for the Euro. I don't believe the Swiss did either, as I see there is a market for Swiss francs. Thus it is bankers that have control of all this mess and they will do as they see fit, as they did in the USA. But, in doing so, it is quite likely that they will upset the apple cart because deflation is going to work in the way it will work regardless of what bankers do.

There seems to be this absurd idea of inflation, which could occur should the private sector be willing to sell their goods for nothing to the state. Being they won't, they will sell out of necessity and to keep their accounts paid and solvent. It is hard to inflate in this fashion, whereas if commercial banks were lending to buyers of private goods to the extent that the inventories were being cleared faster than they could be produced and the new production was clearly more expensive for the same reason, inflation would occur easily. But, inflation is not only a function of age demographics, but a function of how much good credit can be extended by the system. The world is confused with credit as it is with global warming and carbon dioxide. It is assumed that man creates all the carbon dioxide out there when in fact most of it comes from rotting plant and animal matter along with massive amounts vented out of the earth. The same holds true for government and central bank created inflation. The truth is these are only additions to natural borrowing inflation and are insufficient when private borrowing has reached its limit.

The big problem is that everyone wants to preserve the status quo of no mathematical solution except the ones in debt and they want to preserve the status quo of their otherwise good standing. The paradoxes are too many to go into details here.

In the end, if we end up with a world currency, don't be surprised if it isn't the dollar. It is already the backbone of world banking and debts around the world are denominated in it. It would be a boon and a bust to the US though, as the US would be more easily held liable for their debts. It would also undermine US sovereignty, in that the rest of the world would have control of US credit more easily. A currency coming out of Asia is a long shot and the Chinese are already on the dollar and posses a substantial base of them to exert their own financial power around the world. They are already attempting to wield this power.

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Well, gold has really moved much higher since this post was created. gold prices. I just see now way out of this tremendous economic calamity we are seeing. Now with Ben Bernanke issuing another bit of money printing session with the 40 billion dollars of mortgage back securities purchases, we are headed for a dollar devaluation. I'm hoping that precious metals will be a good way to hold onto any money. I woke up a couple of years ago and spend my time researching and researching and that is the only solution i can find.

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