Storm Clouds Over The Euro

The storm clouds are darkening in Europe. Cyprus banking, Italian politics, Spanish unemployment, Greek austerity fatigue, French fiscal targets and German monetary statesmanship all remain potential sources of financial fissures even as the Old World growth data swoon.

In China, there is unmistakable evidence of liquidity tightening by the People’s Bank of China even as the banking regulator targets credit growth and property lending. The emerging markets, led by BRICS, have been a disappointment in 2013, hugely underperforming Wall Street and Japan. Geopolitical event risk is rising, from North Korea to Egypt, Boston to Iran. Yet the growth fault line in global markets lies in Europe.

In February, the Euro rose as high as 1.37 against the dollar and surged against both the Japanese yen and the British pound. The Italian/Cyprus crises led to a swift, brutal fall in the Euro below 1.29 even though the European Central Bank (ECB) is the only major global central bank not to have aggressively eased monetary policy like its peers in London, Washington and Tokyo. The ECB is constrained by both the hard money instincts of the German Bundesbank and its own institutional processes. The “positive contagion” about which Mario Draghi gloated in January seems premature, even anachronistic.

The ECB will not allow another major appreciation in the Euro, even though Signore Draghi insists that the Governing Council does not target or respond to exchange rates. The fall in the Euro since February reduces the ECB incentive to cut its 75 basis point policy rate, at least until late summer when economic contraction, symbolised by the French growth malaise, will deepen. The Bundesbank, like the French generals who built the supposedly impregnable Maginot Line to fight the last war, insists on an anti-inflation mindset in a continent mired in recession and deflation.

After all, it is surreal that the Bundesbank is obsessed with inflation when core Eurozone inflation is 1.3 per cent and Spanish youth unemployment is a horrific 50 per cent. This is neither sustainable nor politically feasible, even though German politics makes it impossible for the ECB to imitate the anti- deflation monetary policies of the Federal Reserve and the Bank of Japan. After all, the fact that the Bundesbank publicly opposed Draghi’s OMT programme last year reinforces my belief that the ECB cannot and will not embrace the global mantra of quantitative easing.

The Troika’s botched Cyprus bailout will lead to a fragmentation in European banking and stealth capital flight from Club Med even as core inflation in Germany and France fall. The inevitable endgame is an impaired transmission of monetary policy at a time when fiscal adjustments are draconian and inflexible.

Bank credit growth in the Eurozone cannot rise, particularly as funding costs and regulatory backlash/ overleveraged balance sheets hit growth. As the Hausbank concept becomes anachronistic even in Germany as restructuring banks slash corporate/funding relationships, Europe is heading for a protracted credit crunch.

The latest IMF reserves data shows that central banks allocations to the Euro have now fallen below 24 per cent at the expense of AAA commodity currencies such as the Norwegian kroner, Australian dollar and the Canadian dollar. Political risk in Italy and Spain/Catalonia, the credit crunch in European finance, a dovish ECB, a spotlight on French fiscal deficits, the fallout from Cyprus, and weakness in PMI all suggest that the Euro is a strategic sell on any strength. The Euro is now a funding currency in 2013.

Gold is now in the downtrend with downside risk to $1250 by July. In retrospect the yellow metal proved neither a geopolitical safe haven nor a hedge against inflation in this global business cycle. This suggests dollar strength can well cause the Euro to fall to 1.25 in the currency market. Sterling is set to loose its sizzle once again this summer.