A strong dollar, euro downside and a gold liquidation panic
Back in July, Ed pointed to some comments by George Soros on currencies that I felt were perceptive. Soros said:
With most major currencies down significantly against the dollar, we now see the truth in that statement. I want to add some color and connect this to my last post on the situation in Europe.
The dollar has been somewhat strong, but still hasn’t broken out decisively. By contrast, the euro has been steadily weakening for the past few weeks. Indeed, since the beginning of the year. It’s even weak against sterling (and the UK, according to Gillian Tett, is about to go bankrupt).
You had the fall from the $1.50 level. We went close to the 200 day moving average on euro/dollar and then euro had a failing rally. And now it’s breached that average and appears to be accelerating to the downside.
The Massachusetts election has nothing to do with this. Read Martin Wolf’s recent piece in the FT. I think he’s got the economics somewhat wrong, but this issue is much bigger than many believe.
The Greek government has promised to slash its fiscal deficit from an estimated 12.7 per cent of gross domestic product last year to 3 per cent in 2012. Is it plausible that this will happen? Not very. But Greece is merely the canary in the fiscal coal mine. Other eurozone members are also under pressure to slash fiscal deficits.
If eurozone deficits have finally got high enough to weaken the currency (because euros are easier to get) then any fiscal tightening moves that drive the deficits up higher will weaken the currency further, setting up a downward spiral.
More downside pressure for the euro
This euro move could really accelerate significantly to the downside. My point is that the weakness does have broader macro implications in a way which is unique to the euro zone.
The Eurocrats had the chance to deal with their problems from a position of strength when the euro was strong. Now the market is beginning to focus on the institutional flaws and mounting stresses which are the product of a horrible monetary system. Weakness in the euro could well generate more panic as the euro zone nations respond by embracing yet more fiscal austerity, which in turn will increase the deficits and likely trigger even more euro weakness.
During a period of euro weakness funding problems could become worse and spread to other euro nations. When foreign governments buy euros for their portfolio of FX reserves, they have to hold them in some kind of account or security. Most probably opt for eurozone national government paper. Same with international institutional investors. When they stop adding to their euro portfolios and/or reduce them, they stop buying and/or sell that paper.
The new holders of euro (those who buy the euros when portfolios sell them) may or may not buy that same government paper, and the euros may instead wind up as excess reserves at the ECB in a member bank account, or even as cash in circulation as individuals who don’t trust the banks turn to actual cash. The banks with the excess reserves may or may not buy the national government paper or even accept it as repo collateral, to keep their risk down, and instead simply hold excess reserves at the ECB.
Markets will clear via ever widening funding spreads as national government paper competes for euros that are otherwise held as ‘cash reserves.’ The amount of reserves held at the ECB doesn’t actually change, apart from some going to actual cash.
What changes are the ‘indifference levels’ yield spreads – between having cash on your books and holding national government paper risk. And the ability to repo national government paper at the ECB doesn’t help much. Would you buy Greek paper today if you were concerned it might default just because you could repo it at the ECB, for example?
Further, while Americans go to insured banks and Treasury securities when they get scared, Europeans exit the currency as they have a lot more history of hyper inflation. That means a non virtuous cycle can set in with a falling euro, making National government funding problematic, which makes the euro continue to fall. This happened a little over a year ago due to a dollar funding liquidity squeeze. The Fed bailed them out with unlimited dollar swap lines and the euro bottomed at something less than 1.30 to the dollar.
This time it’s not about dollars so the Fed can’t help even if it wanted to. And the ‘remedies’ of tax hikes and/or spending cuts Greece intends to pursue will only make it all worse, especially if undertaken by the rest of the eurozone as well. Fiscal tightening will only slow the economy and cause national government revenues to fall further unless the taxes are on those taxpayers who will not reduce their spending (no marginal propensity to spend) and the spending cuts don’t reduce the spending of those who were receiving those funds.
The treaty prevents ECB bailouts of the national governments, so any bailout from the ECB would require a unified Fin Min action and an abrupt ideological reversal of the core monetary values of the union towards a central fiscal authority.
This is somewhat analogous to what happened to the US when the original articles of confederation gave way to the current constitution in the late 1700’s.
Interesting to me that gold is getting caught in the crossfire. This sort of confirms my initial hunch that this sort of systemic problem is deflationary in the first instance. Water is still leaving the bath tub and those who bought gold for inflationary reasons (not everybody) are bound to be disappointed.
Here is something else on gold. I was chatting about the gold market over the last weekend with a friend who said something to this effect:
Gold is ‘over-owned’ by hedge funds in a major way. Fund positions could be as large as the official bullion hoard before hedges. The physical market has been in surplus for years. The funds are long futures and forwards with dealers having to take the other side, hedging themselves by buying physical.
To this fund mania, one must add huge speculation in real assets in China because of the enormous expansion of credit there. This ‘love affair’ with commodities is an echo bubble – and the Chinese credit expansion has created giant leveraged positions that could lead to panic liquidation at some point.
The guys who are long this stuff just don’t understand that, in small commodity markets with large surpluses, you can never sell a position when everyone is on the same side of the trade. It is as simple as that.