Posted on Saturday, April 28th, 2012 | In Market Commentary
If you pay attention to finance and economics, you probably understand the common argument against the U.S. dollar:
The Federal Reserve’s monetary policy of targeting price levels and full employment, when extremely accommodative, reduces the value of the currency as money supply grows and interest rates are kept low.
That’s why the ongoing campaign by the Federal Reserve to stimulate the economy via quantitative easing, Operation Twist, a 2 percent inflation target (an unconditional aversion to deflation), and an extended period of lowly managed interest rates is such a downer for the greenback.
The markets have seized on the monetary (and fiscal) headwinds blowing hard against the dollar. But everything that’s happened in the U.S. financial system in the last 3+ years has happened or is still happening in Europe.
Why doesn’t the euro seem to be at the
mercy of Europe’s monetary/fiscal backdrop?
Despite all the money the ECB/EU/IMF threesome have committed to alleviate financial system pressures, the euro has not behaved in similar fashion to the dollar! The reason is quite simple, but the understanding is rather complex.
I could tell you the euro is a sort of alternative reserve currency and moves inversely to the dollar based on capital flows. And then I’d be done and tell you to go have a nice day.
But there is a very important little detail that will help you understand what’s helped the euro seemingly defy gravity in recent months … and it’s the one to watch to determine when the euro will lose its support.
You may have heard the term repatriation used to describe why the value of the Japanese yen performs well when market risk is high. That is: Japanese investors bring their money back home which requires they convert their investment capital back to yen, thus boosting the currency’s value.
In Europe the mechanics are ultimately the same, but the catalysts are somewhat different …
Here is a quick explanation of the coming European repatriation, from The Economist magazine [my emphasis]:
There is a faster route to funding salvation than reducing bread-and-butter commercial lending. One particularly striking feature of the pre-crisis expansion of Europe’s banks was that so much of their activity was in dollar-denominated areas such as commercial-property lending, leveraged buy-outs, syndicated loans and commodity financing.
Some of that dollar activity was funded by deposits gathered by banks’ American units; another wodge of dollar funding came from swapping local deposits into foreign currency. But lots was gathered on wholesale markets, often in the form of short-term debt that needed to be constantly rolled over (think of the money provided to French banks by American money-market funds, whose flight from Europe last year caused so much trouble).
This type of funding—short-term, wholesale and with an added dollop of foreign-currency risk for good measure—could not be further removed from the liabilities lenders, or their regulators, now want. With French banks in the vanguard, they are offloading dollar-denominated assets.
Simply put: European banks hold a meaningful amount of U.S. dollar-denominated assets.
Ok, so …
When Will All This
Obviously, for this understanding to pay off, we have to have a general idea of when the shift in flows to the euro will take place or, more precisely, come to an end.
The IMF, in their Global Financial Stability Report released two weeks ago, suggested the deleveraging would be comprised mostly of asset sales, weigh in at around $2.6 trillion and last for 18 months. This deleveraging will represent an additional headwind to euro-zone economies, as credit supply to the real economy shrinks to some degree, but capital flows won’t necessarily burden the euro at first.
Once this deleveraging of dollar-based assets approaches an end, the European Central Bank will likely have already begun unconditional monetary accommodation to stem the credit and growth pressures of deleveraging and fiscal austerity.
Already they are working with the IMF to create more unconventional money pumping — specifically, allow the European Stability Mechanism bailout fund to directly stimulate insolvent banks. But it is only after most of the deleveraging is complete we will see additional money pumping by the ECB become a stigma for the common currency and pressure the euro lower over time.
The growing impediments between national financial systems reduce the amount of investment flowing between countries. Achieving any foreign investment exposure through other avenues means using the bond markets. While the underlying fundamentals in Europe will change very little over this time, if not become notably worse, the relative appeal in the safety of U.S. Treasuries may help spark the redirection of previously repatriated capital.
At that point it may not matter if the Federal Reserve is still on the path to currency debauchment … the euro may get cooked. April 2012 plus 18 months equals October 2013.
And It Might Not
Take That Long!
Perhaps the deleveraging will trickle all the way into the Fall of next year, but the market should respond sooner than that as it anticipates the change in flows. And even sooner if the deleveraging sparks some type of systemic panic across the global banking system which, of course, would apply new pressures to economies that are already barely treading water if not still fighting for air.
JR very briefly presented such a scenario involving a blow-up of global derivatives in my Money and Markets column four weeks ago. The interconnectedness of banks through derivatives seems to present a climate that’s ripe for a systemic panic.
P.S. For daily currency and macro views with detailed charts and much more, be sure to visit Money and Markets blog — Currency Corner.
About Jack Crooks (http://blogs.moneyandmarkets.com/blog/currency-corner)
John (Jack) Crooks is the founder and president of Black Swan Capital, an independent advisory firm specializing in foreign exchange and currency markets investing for retail and institutional clients. A seasoned financial advisory with nearly 20 years of investment experience, Mr. Crooks uses both quantitative and qualitative approaches to determine the fundamental driving force(s) behind the movement of the currency, capital, and commodities markets. He is the editor of Weiss Research’s latest investment offerings, World Currency Alert and World Currency Options, which were launched in August 2007. Mr. Crooks also founded Ross International Asset Management, a discretionary money management firm specializing in global stock, bond, and currency asset management for retail clients. Previously, he was general manager of Plexus Trading, where he specialized in currency futures and commodities trading. During his successful career, Mr. Crooks served as chief currency and futures strategist of M2 Futures Inc., an investment boutique headquartered in Chicago, as well as vice president of Global Strategic Research for an international investment boutique, where he was responsible for providing daily advice and global strategy analysis. Prior to entering the investment arena, Mr. Crooks held various corporate finance positions. He has written extensively on the subject of global currencies and international economics and has been published in Asian Times, Futures Magazine, Barron’s, Bloomberg, Dow Jones Newswire, and across many financial websites. He has also appeared on Bloomberg TV and CNBC. Mr. Crooks holds a bachelor’s degree in finance from Florida State University and a master’s in business administration from the University of North Texas.