7 Reasons Why The Euro Is Headed To Parity With The US Dollar

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Markets celebrated throughout the world last week when the European Central Bank decided to follow the lead of the US and the UK by printing money by the bucketload.

The euro, since it has existed, has been a strong and reliable currency. This isn’t because of the underlying governments, which are as bad as governments anywhere. Nor is it because the economies have been strong or weak. It’s because the Germany’s influence on the ECB prevented it doing anything idiotic, such as printing money, buying sovereign junk debt, or keeping interest rates at absurdly low levels.

As a result, the US dollar fell from 1.07 euro at the start of Bush Jr’s term to 0.77 at the end. The result: a 28% decline in the value of the US dollar. It would have been over 40% if the financial crisis hadn’t been engineered.

The dollar losing 28% of its value had the embarrassing effect of reducing the world’s #1 economy to the world’s #2 — though most American publications like to ignore this fact.

With Germany vehemently against the ECB doing any of the circus acts of the Fed, the euro was widely seen as the preferred currency to be in. After all, the euro was as good as gold — there was a limited amount of it and it wasn’t being created out of thin air like the US dollar, the UK pound, and the Japanese yen.

From the moment Obama took office to the end of November that year (2009), the dollar lost 14.8% of its value. Something HAD to be done.

Now, I don’t want to cast aspersions here, but we all know that ratings agencies are either corrupt or incompetent or more likely both (remember all that “AAA” mortgage backed securities that ended up worth cents on the dollar?).

Having said that, it’s interesting that just at the US government’s time of need (to issue record volumes of debt), the rating agency Standard & Poor’s put Greece on ratings watch with a negative outlook on December 7, then downgraded the debt a week later, again in March, and again on April 27. In just five months, Greece’s long term foreign currency rating fell five ratings from A- with stable outlook to BB+ (junk grade) with negative outlook.

S&P has NEVER downgraded a sovereign A- rating this fast since it began sovereign ratings in the 1970s.

Other notable attacks on eurozone countries by S&P were:

Portugal — went on credit watch on December 7 last year, downgraded on April 27
Spain — same as Portugal
Ireland — downgrades in March and June last year
This isn’t to say that Greece didn’t deserve the credit rating. Heck, the country probably didn’t deserve even a BB- at the time it joined the euro. That brings me to my first point:

1. The PIIGS will NOT implement effective measures to bring down their deficits

When Greece joined the eurozone, it had a budget deficit equivalent to 1.6% of its GDP — down from 10% in 1995 — thanks to a major selloff of state owned companies. But you can only sell so many state assets.

Upon joining the eurozone, Greece projected its 2001 budget to be just 1.3% of GDP. But without more assets to sell off, the budget blew up.

By 2006, Greece got its deficit back down to less than 3% of GDP as per the rules. Or, to put it another way, since Greece joined the eurozone it has only once gotten under the 3% deficit limit.

But “this year will be different”. Sure. Every year since 1997 Greece’s budget deficit has been revised sharply higher. In 2001, for example, Greek accountants “forgot” to book €1.6 billion of defence spending. In 2009, the budget blew out slightly from 3.7% of GDP to nearly 14%.

For the 2010 budget, Greece has promised to improve the deficit by €4.8 billion. With a gun to its head, the Greek parliament passed the bill. But just as with its promises in the past, the bill is a mere promise to collect more and spend less.

The reality is that it’s more important to get re-elected this year than to worry about what’s happening next year. So, not much will get done and we’ll be back for more in 12-18 months.

Italy, Portugal, Ireland, and Spain aren’t going to be much different. I’m just picking on Greece here because of its trade deficit: Greece imports three times as much as it exports: $64.3 billion vs $21.4 billion. This is a unique recipe for disaster. 12 months from now.

2. The ECB is now essentially monetizing PIIGS debt

The European Central Bank (ECB) now has a €750 billion (around $1 trillion… for now) plan in place to buy eurozone sovereign and bank debt. This is bought with brand new money. Essentially this means that no matter how much the PIIGS go out of control with their spending, they can depend on the ECB to guarantee their debt by buying it up.

The €750 billion will be enough for Greece (around €400 billion), but it won’t be enough for the combined PIIGS, and the “shock and awe” value is rapidly wearing off as financiers run the numbers.

Now that the central bank has gone down this road and the pressure is off the PIIGS governments, it will be a self reinforcing cycle creating a steep vortex directly into the sewer.

3. The ECB is now monetizing European bank debt

Along with sovereign debt, the ECB is buying up a bunch of European bank paper. Why?

European bank account for about three-quarters of the $4.7 trillion of cross-border loans to emerging markets.

A large portion of those loans are to Hungary, Poland, Ukraine and other eastern European countries that have been even harder hit by the recession. European banks made euro loans to people and businesses with local currency revenue streams, which means when the local currencies tanked, the loans went the same way as the sub primes in the US.

Europe has two choices: either bail out the banks (bad for the euro) or devalue the euro. At this stage, the ECB seems set on doing both.

4. The world’s central banks will begin rebalancing their portfolios from the euro back into dollars

One of the major reasons for the dollar’s demise was central banks losing their religion and buying alternative currencies. The euro was the obvious one and has been gaining momentum over the past ten years.

Purchasing the euro was a simple decision: the ECB was financially disciplined and had Germany there to keep it on the straight and narrow.

Selling the euro is just as simple: the ECB has stepped into the La-la land of sovereign bailouts and Germany was simply overruled.

5. The US Federal Reserve is now more dependable than the ECB

Sad but true. The world knows the Fed will keep rates down for 2 years. The world knows the Fed will paper over anything beginning with an R. The world knows the Fed will bailout banks next time around as well.

This is all factored into the price. But who on earth knows what the ECB will do next? That’s a mystery even to the ECB!

Better the devil you know…

6. Germany will either leave the euro or kick out the PIIGS

Already 59% of Germans believe the government should consider returning to the deutschmark. When they see inflation begin to take hold because of the new “Print Money To Bail Out PIIGS” policy, the other 41% will join in. The German constitutional court will also have something to say about the bailouts, which are in a direct violation of the German constitution.

The prospect of kicking out the PIIGS seems to have become rather more difficult now that Germany was overruled and they have their snouts firmly in the trough. But if Germany’s central bank can find a way of doing so, it probably will. Otherwise it will have to leave.

Needless to say, if the largest economy and most financially responsible central bank leaves the euro, then the currency will go the way of yesterday’s Zimbabwean dollar.

7. The US — along with its ratings agency friends — will continue what it started

As I said at the start, the US doesn’t take kindly to threats to the dollar’s hegemony.

We all know what happened when Iraq started selling oil in euro and yen. The writing is also on the wall for Iran, which is now doing the same thing.

With the euro now under siege, the ratings agencies have carte blanche to downgrade just about any nation within the eurozone.

If one looks at Germany on its own, the economy and currency seem rather stable and well managed. But once you throw in other countries in the eurozone that have deficits of more than 3% — i.e. every country except Germany — the eurozone financial management seems to be spiralling out of control.

With higher taxes and less spending, the European economy isn’t going to get much growth for the next few years, which will mean projected tax revenues will be well below forecasts — especially in Greece.

It won’t take much for the ratings agencies to downgrade the whole mess. With the US treasury likely to issue $1.5-2 trillion in debt this year, it may need to make the euro look even less attractive to guarantee buyers at today’s absurdly low rates.

The final blow for the euro will be when S&P or Moody’s downgrades Germany and France simply because they are effectively guaranteeing the debt of the rest of Europe.

This is years off yet, but it’s the logical result of the direction the ECB has decided to take.

So, with the euro in freefall, the yen getting pummelled, and the pound taking a well-deserved thumping, the US dollar is looking nice and strong. It’s a wonderful perspective: calling a weakening currency strong.

The three better measures of value — land, gold, and oil — are going to go streaking by so fast that we’ll hardly notice them climb to $1,500 an ounce, $120 a barrel, and 2006 levels for property.

Source : Peter of TheOstrichHead.com

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