Special Report Reprint

Key News

  • The euro slipped on Tuesday after Germany demanded painful new austerity measures from Greece in return for badly needed financial aid, with investors likely set to push high risk European sovereign bond yields up further. (Reuters)
  • China faces a cloudy international economy that is likely to drag down export growth later in the year, squeezing exporters’ profits and stoking trade friction, a senior Chinese commerce official said. (Reuters)
  • Spanish unemployment in the first quarter of this year surged to a record high over 20 percent, according to media reports, (Reuters)


“The world is a tragedy to those who feel, but a comedy to those who think.”

                           Horace Walpole

FX Trading – Special Report Reprint

REPRINT: Key Reasons Why the Euro is Heading to Par or Beyond against the US Dollar

The following is a reprint of the report we sent to our clients over a month ago. (This report is the second part of a report we published in June 2009 explaining why the major structural problems within the European Monetary Union could lead to a breakup. If you would like a copy of our original report, please request via email.)

There have been changes to some of the charts, i.e. spreads, we present in this piece, but our forecast for the euro has not changed.

In fact, here’s a quick peek at the Greece/ German 10-yr interest rate spread …exploding even higher to record levels in the last two weeks … indicating how quickly the market is now catching up to the inherent risks of Sovereign default.

The only question we have is whether or not the euro goes to par quickly on some type of Eurozone crisis, or just grinds lower and lower in the months ahead. Either way, we want to remain positioned short the euro against the dollar and ride this move for all its worth. This research piece lays out the key reasons why we are confident in that view.

Summary Rationales:

1. Sovereign default is a real possibility; at best the market is under pricing the fiscal risk facing the Eurozone and its potential impact on the euro.
2. Germany’s incentives to remain in the European Monetary Union
are fading fast; they are now playing hardball but their growth is in jeopardy.
3. Even if the zone muddles through the crisis, the euro likely grinds lower on valuation and risk.

Euro Spiraling Lower

Greece and friends likely lead to the path of sovereign default; if not default, we could see a huge hike up in risk across the zone; that alone would likely hammer the euro.

Greece is on everyone’s radar screen. And though the other fiscal basket case countries have been mentioned, the market doesn’t seem to have caught on to the fact that taken collectively the countries of Greece, Spain, Portugal, Italy, and Ireland have a worse debt profile than Greece. Hard to believe but true…

*Not one country can satisfy its funding needs through current tax receipts. Source: Leto Research

The therapy plan to improve the ugly fiscal picture of the PIIGS above is austerity (more on this regarding Germany’s dominance of trade in the next section). Okay, fine. But, look closely at the bottom again, titled Government funding need as a % of tax revenues; this means that now, before any level of austerity has been imposed, these countries cannot fund government needs. Austerity measures should lower government needs, granted, but it will also clobber existing tax receipts because the burden of austerity will fall on the private sector; they are already overburdened with debt and taxes.

Additional burdens placed on the private sector will likely increase bankruptcies and social unrest and kill growth in these countries. Collectively the economies of these five represent approximately 33% of the entire Eurozone economy.

Once the market realizes that so-called austerity measures won’t work, all of these countries bonds will most likely get hit very hard, pushing yields sharply higher, making funding that much more difficult.

Who’s left to bail them out?

The government has already spent hundreds of billions bailing out the European banking system thanks to the impact of the credit crunch by distributing taxpayer funds to take the bad debt off the bank balance sheets. All that “saving of the banking system” even though PIIGS country balance sheets were already in dismal shape makes you wonder. Now it appears there is a train wreck in the making.

The PIIGS are collectively sitting on a whopping $2,946 billion (€ 2,166.6 billion) of short-term external debt; and a colossal $8,152 billion (€ 5,994.2 billion) of the long-term variety.

It appears to us the market has not priced in this funding risk.

Below is a series of charts showing the 10-year bond spread for each of the countries above compared to Germany (the solid credit in the Eurozone at the moment); it means these countries have to pay that many more basis points in yield to borrow (sell their bonds) on the open market:

Portugal: 130 basis points over Germany.

Spain: About 80 basis points over Germany.

Italy: 84 basis points over Germany.

Ireland: 143 basis points over Germany.

Greece: 335 basis points above Germany. (Updated above)


Key point: Relative to individual debt levels, there is a lot more risk to be priced into these bonds. Another interesting point is this: When you look at the individual spread charts above, what really stands out is the fact that, with the exception of Greece, spreads in the remaining countries have not yet reached their credit crunch highs set back in the fourth quarter of 2008. Risk of default among any one of these countries likely means all these spreads will surge above those old highs.

German incentives to be a part of the European Monetary Union are fading fast.

One key important factoid to remember when thinking of the European Monetary Union is this: One of the primary goals was to provide German industrialists with a captive market for exports. Close to 50% of German exports are now derived from the Eurozone economies.

If the solution to the current crisis is for countries to implement deep austerity, it will clobber Germany’s exports. And yet that seems the only alternative, and here’s why: Germany has a massive lead on all these countries in terms of labor productivity, which translates into massive manufacturing efficiencies compared to the rest of the countries in the Eurozone. How can these other countries export their way out of their fiscal problems when they effectively compete with Germany for the same relative export share? They cannot. And it is highly unlikely Germany would purposefully toss away its manufacturing advantage for the sake of Eurozone unity.

In fact, it is precisely because these countries took on so much debt to buy German industrial and consumer goods that has led to the fiscal crisis and massive German current account surpluses.

German Current Account Balance SA:

German Industrial Production thru Jan 2010:

Despite the global “recovery,” the German engine is sputtering a bit.

Two key points:

1) German politicians will effectively commit political suicide if they ask their taxpayers to backstop the PIIGS —you saw the massive exposure above; that is why Angela Merkel, the German president, has driven a stake through that idea of Germany offering some type of guarantee for Greek debt after that idea was initially floated.
2) If as we suspect, growth in the Eurozone grinds lower and lower, it hits the paymaster—Germany—quite hard. It’s growth will in turn be slowed, and thus it will be that much less willing to take on new commitments; this is likely why German finance minister Schäuble recent hard-line comments implicitly hinted at a German escape from the Union; and explicitly said those who don’t keep their promises should be penalized and/or expelled.

Bottom line: Germany is the economic engine that drives the Eurozone economy. If German growth contracts as a result of austerity across the zone, it will feed directly into the price of the euro and push it lower. If one or more of the countries in the zone decide they want to leave, the euro likely takes a big hit even if it remains intact. And on the less likely chance that Germany signals it is done with the experiment known as the euro, it would be lights out for the single currency.

Even if the Eurozone muddles through the euro likely grinds lower on valuation and risk.
It is highly unlikely the PIIGS, facing such fiscal woes, can export their way out of the problem. It seems the best outcome is a broad acceptance of austerity measures. Success on this front will hammer relative growth across the Eurozone. So the euro, as a currency, is now left to find its own level in a slow-growth high- risk environment where the central bank can ill afford not to keep monetary policy loose.

Monetary aggregates, consumer lending, rising unemployment, and subdued inflation suggest the European Central Bank cannot afford to be tight.

European M-2 growth is falling:

Money is not getting into the real economy; consumer credit is falling:

Unemployment continues to rise in the Eurozone:

Inflation is under control; year-on-year % change in CPI:

Key Point: This is hardly an environment where the European Central Bank can hike rates; in fact we think there is a good chance if growth grinds down the ECB may actually cut interest rates.

We think US dollar interest rates will soon be above Euro interest rates on the short-end of the interest rate curve; US rates are already higher on the long end:

US yield curve (black) vs. Eurozone yield curve (red):

Thus, US yield differential could soon trump the Eurozone by a large margin. Yield differential is one of the two most powerful drivers for currency prices over the longer and intermediate-term time frames; the other is relative growth.

 Yield differential
 Relative growth

The US economy looks far better to us than the Eurozone on both counts here.
[By saying this, we are by no means saying the US is wart free. We are implying one key aspect of currency pricing that is often overlooked—currency pricing is a relative game.]

Below is an interesting chart comparing the yield on US 10-year benchmark bonds to 10-year German bunds, and below it is the price action of the US dollar index. You can see the direct correlation. As this yield differential rose in favor of the US dollar i.e. German yields fell relative to US yields on the 10-year benchmark, the dollar rose; a perfect example of yield differential at work.

US 10-year Note Yield (black) vs. German 10-yr Note Yield (red) Daily:

US Dollar Index Daily:

We believe this spread will continue to widen for two reasons:
1) US economic growth picks up and its long yields rise accordingly
2) German bonds continue to be the safe haven in Europe because of the risk of holding the PIIGS bonds; that and lower growth likely means German bond yields stay or fall further over time.

…thus, more money flows to the US on a growing positive yield differential and increasing risk across the Eurozone.

According to the latest Economist magazine’s Big Mac index of March 17th, 2010, used for measuring relative fundamental values of global currencies against the dollar, they show the Euro area currencies presently about 25% overvalued against the US dollar.

EURUSD = 1.3500 – 25% fundamental overvaluation = 1.0125

Close to par against the dollar only if the fundamental valuation premium is stripped away! It’s why we titled this research piece: “…Par or Beyond…”

The rising risk of implosion of the European Monetary Union is rising. That risk is the catalyst for a very powerful self-reinforcing process that chases huge pools of capital away from the euro and into US capital markets to hide. We think the euro at par will become a reality. A fall to 0.8300 against the dollar would only represent a round-trip ticket from where the bull market in the euro began back in late 2000—stay tuned and stay short the euro.