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"Like George Orwell, Mr. [Vaclav] Havel described ‘living within the lie’. Both saw how the dishonesty inherent in such acquiescence ultimately corrupted all aspects of life, personal as well as political. Themselves masters of language, both men understood that the abuse of language was central to that corruption. In 1984, and even more effectively in his essay on political language, Orwell explained how political rhetoric was constructed by sticking together reiterated phrases that had ceased to be connected to their literal meaning.”

                               John Kay

FX Trading – ECB Looms and ERM risks rise!
A while back we started talking about the risk to breakup of the European Exchange Rate Mechanism (ERM).  Of course the usual howls of disbelief we usually get when we look in the opposite direction of the consensus.  But the reality is, spreads are widening fast among the various sovereign bond markets in Europe–the market is pricing in risk–something that isn’t supposed to happen within the ERM. 

“Spain was warned on Monday by S&P about its high levels of public and private debt, while Greece and Ireland were told on Friday that their deteriorating public finances could lead to downgrades.

“This has led to a sharp widening in the gap between German bond yields and those of other eurozone countries.

“But they are not the only European Union countries to have been warned that their credit ratings may be downgraded because of deteriorating public finances.

“On December 22 Fitch Ratings cut Lithuania’s long-term foreign currency issuer rating from A- to triple B+, explaining that the risks to fiscal stability were likely to grow as the country fell ever deeper into recession,” according to the Financial Times.

Heck, why shouldn’t Italy, Ireland, Spain, and Portugal be able to borrow at conservative German interest rates?  Heck, we are one cohesive unit!  Yeah…sure you are…

If Germany had its precious D-mark back, it would likely be crushing the competition.  Instead, the D-mark has tied its wagon to a conundrum. And now, instead of traders snapping up any German sovereign bond offering–the ERM baggage is repelling them as so happened yesterday. 

We wholeheartedly concur, and have said so many months ago, with this comment from GaveKal research, published recently in the Financial Times (6 Jan ’09):

“The important question of 2009 will be whether Milton Friedman’s prediction that the euro will not survive its first recession intact will turn out to be prophetic”. 

Sadly, does this negative news about Europe do anything to improve the ugly picture in the US?  Absolutely not!  And therein lays the extreme perversity of this game of currency trading.  We often end up holding positions that aren’t based on any particular merit other than it’s a lot worse somewhere else.  This we think is why so many people are perplexed by the dollar–they focus only on US economic ills, which are many indeed. 

I can’t remember if we shared this chart before with CC; we have with our Members.  It is a comparison of the path of the euro relative to the path of emerging stock markets.  The two have been tracking very tightly.  Why?  Well, probably a lot of reasons.  But one of the main reasons we believe is the incredible relative exposure of European banking to the emerging (read sub-merging) markets.  Simply put–the emerging economies can’t repay the loans to foreign banks when demand for their exports (commodities and manufactured products) has vanished. 

MSCI Emerging Market Index (black line) vs. Euro-USD (blue line) Weekly:

“As Miroslav Kalousek, finance minister of the Czech Republic, which holds the EU’s rotating presidency, said in an FT interview last week: ‘Often I’m woken at night by a nightmare–how am I to refinance the debt.?'” (FT)

The question: Is all of this already in the price?  Tomorrow the ECB gives us its rate decision.  Mr. Trichet will speak.  Will it be buy the news or sell the news?  A clue there we do not have.  But we do believe the pressure will continue to grow on the ERM for many months to come.