The euro’s survival hangs in the balance as worries about
weakening fundamentals that have dogged private sector investors since the
onset of the global financial crisis are now spreading to reserve managers at
official sovereign institutions.
The European Central Bank is hardly helping matters.
Repeated policy failure has seen the bets stack up that the euro will fall to
re-test parity with the US dollar in the near future.
The risk is that the combination of weak euro fundamentals
and the dollar’s correction from its massively oversold position could take the
rate a lot lower.
Dollar bulls are on a stampede and the euro/dollar exchange
rate could easily get trampled down to 2000’s US$0.8228 low. Historical
precedents do not end there.
Back in the 1980s, when the dollar was at the peak of its
super-strong cycle, the ‘synthetic’ euro was low as US$0.5698. That implies a
halving in value for the euro in a worst case scenario.
Right now, the fundamentals are clearly stacking up against
the euro – relative growth, inflation, interest rate and bond yield
differentials all undermine confidence in the currency.
The euro zone is being sucked into a downward spiral of
recession, deflation and deeper debt. A third recession in less than five years
seems on the cards. Headline inflation has sunk to 0.3 per cent - a whisker
away from negative territory. Employment prospects remain grim. The euro zone
jobless rate is stuck near to its 12 per cent record high.
By comparison, the US is notching up 4 per cent-plus growth,
inflation is almost back to the Federal Reserve’s 2 per cent target and new
hiring is surging. The juxtaposition of US unemployment sinking to a six year
low of 5.9 per cent in the October employment report is not lost on the
markets. The dollar surged 1-1/4 per cent against the euro in the wake of
Friday’s US payrolls report.
Diverging interest rate and bond yield differences could
pile a lot more misery on the euro in the coming months.
While the euro zone could be stuck with negative interest
rates for years, the Fed is preparing the markets for rate hikes. The job of
‘normalising’ Fed monetary policy could easily take US official rates back to
3-4 per cent in the next two years.
With 10-year US Treasuries now yielding 150 basis points over
euro zone government bonds, it lessens the euro’s appeal even further.
Euro zone policymakers are in disarray. They are hitting the
panic button on fiscal and monetary stimulus in a last ditch attempt to bolster
growth and jobs – and rescue monetary union in the process. But by doing so,
they founding policy icons of currency union are being systematically pulled
down. Markets are not impressed by what they see.
Fiscal consolidation has been put on the back burner. France
has abandoned any attempt to reel in its budget deficit. Other countries look
set to follow. Deficits and government debt across the euro zone look set to
mushroom.
The weakest link is the ECB. Markets now see it as a
lame-duck policymaker. The delay in launching full-blown QE was largely because
of opposition from Germany’s Bundesbank. The rift does not impress the
markets.
Data shows that speculative positions are starting to build
against the euro. Investors are switching from US dollars to the euro as the
best funding currency to finance carry trades in emerging markets – especially
with ECB rates set at zero for quite some time.
But the bigger risk is that central banks are losing faith
in the euro as a reserve asset. International Monetary Fund data shows that
since the financial crisis the euro’s share of global central bank reserves has
slipped to 24 per cent from a peak of 28 per cent.
If reserve managers abandon the euro, the outflow could
quickly turn into a tidal wave. In that scenario, the target of parity for the
euro against the dollar would get very quickly submerged.
Reprinted courtesy of South China Morning Post
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