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.
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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