Euro: close to the edge

The euro is getting close to the edge again. Cyprus is not the root cause, but the effect of the crisis that has been building in the Eurozone for years. Irrational exuberance in the banking sector, really bad budgetary control and a deepening divide between the economic Haves and the Have-Not underlines little hope of this having a happy ending. Cyprus should not be underestimated. Cyprus could well be the trigger for a much deeper debacle in the peripheral markets if the Eurozone fails to stop the contagion from spreading. Make no bones about it. The Eurozone authorities have seriously goofed on the bail-in proposals. The Eurozone ‘bright ideas’ department may have come up with a Baldric style ‘cunning plan’ over the bank levy proposals, but it is not going to impress anyone at ground level. The people of Cyprus  are going to have to pay the penalty for the misdemeanours of the over-blown banking sector and years of bad budget fundamentals. And they are now starting to kick back hard. There is about as much hope of getting the two-tier bank levy through in its initial form as hell freezing over. The Cyprus parliament’s new draft bill might have a better chance of passage. This suggests a zero tax levy on deposits up to 20,000 euros, 6.75% on deposits between 20,000-100,000 euros and 9.9% for deposits over 100,000 euros. In the bigger picture it  is simply re-arranging deckchairs on the Titanic. If this is rejected in parliament or resisted by public opinion, Cyprus would be forced into default and driven out of the Eurozone. The euro would be left stigmatised.

If the Cyprus government can swing the latest proposals past the electorate then fine. It simply kicks the contagion can a little further down the road again. But it will not go away. The euro looks a doomed ship. It may not be a sudden submersion, but the odds are that the euro is so fatally holed below the waterline that any hope of challenging the US dollar’s reserve currency status are wrecked forever. The problem with the bank levy proposal is that the Eurozone authorities have opened a new Pandora’s Box of uncertainty. It sets a precedent for potential bank runs if depositors get even half a whiff of a future bail-out. Depositors and institutional investors will vote with their feet and look for safer havens to bank their cash. That means the front end of the German yield curve, the Swiss franc currency and gold will continue to be the market’s on-going friends. Ironically, even the much debased US dollar will start to show its lustre again, much as it did in the second half of the 1990s when Greenspan’s irrational exuberance regime attracted massive capital inflows into the ill-fated US dot.com boom, pushing the dollar higher in the process. With the US authorities opening up the stimulus floodgates in such grand style again, the US dollar should regain its growth spurs, especially relative to the recession-bound and contagion-ground euro.

There may be some short term relief rally from a Cyprus compromise in the next few days, but the fundamental odds have clearly shifted against the euro in the long term. With the US economy continuing to show signs of better economic spring, at some stage, the markets will begin to factor in the prospect of the Fed applying a future touch on the policy brakes. With the ECB looking set to cut rates again, in conjunction with more proxy QE in the form of extra LTROs, the euro will come unstuck. This will be compounded by further escalation in the Euro-crisis. Italy and Spain are all waiting in the wings. Meanwhile popular opinion is turning against enforced austerity. If the peripheral nations start to take a leaf out of the French counter-cyclical book, then the euro will be flushed out. The trend looks set for a test of USD1.25 in the next 1-3 months and a shift below USD1.20 is the fate awaiting the euro in the next six months. It is going to get a lot worse for the euro before there is any chance of redemption, if at all. It should be more of a fight for its very survival in the next couple of years. And who could rule out a Pythonesque ‘dead as a parity’ play for the euro ahead? It’s been there before and it deserves to go there again.