The euro could still have much further to fall
By
MoneyWeek Editor
John Stepek Apr 22, 2010
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The volcano in Iceland has been credited with several economic side-effects, many of them slightly odd.
For example, one website dedicated to aiding and abetting adultery claimed to have had far more hits than usual from mobile devices while people were stranded in airports.
We even had one truly stupid press release from an estate agent trying to somehow suggest that the grounding of flights would lead to a short-term jump in the price of houses under flight paths. Thanks – we'll be sure to stick that trade in our portfolios.
Most of these of course, are just blatant PR-grabbing attempts. But it's probably fair to say that Eyjafjallajokull hasn't helped the situation in Greece any. Delays to the International Monetary Fund team's talks in Athens haven't helped tensions in the bond market.
But now the talks – scheduled to last a fortnight – have begun. So what happens now?
You can't call the market's bluff
There's no question about it. The market just doesn't believe that Greece can be saved painlessly.
More on the eurozone's debt crisis
• The Greeks are bailed out for now - but who's next?
• How to play a struggling euro
• Why Germany should dump the euro
Before there was any question of the IMF or anyone else coming to the rescue, the highest that Greek ten-year bond yields had risen was just over 7%. That freaked the European Union badly enough that it felt forced to step in and say it would bail Greece out if necessary.
But then the markets said: "Well, just how much are you willing to commit?" And the yield climbed higher, peaking at around 7.5% this time. After much to-ing and fro-ing, we finally got a commitment to €45bn between the EU and the IMF.
Satisfied? Not on your life. After a brief dip, Greek ten-year bond yields are now at fresh highs of more than 8%. Because now that the offer of money is on the table, the market wants to see it. Everyone knows that Greece is going to need it. As Gavan Nolan at credit analyst Markit put it: "Current market yields imply that it is a matter of when and not if the package is activated." The question now is, when push comes to shove, will Germany shell out?
It's a useful lesson. You can't call the market's bluff. It knows when the firepower is there, and when it's lacking. It's like when George Soros made his money by betting against the Bank of England in 1992. He knew that all the jawboning and interest rate hikes in the world couldn't keep Britain in the European Exchange Rate Mechanism (ERM).
It's the same for Greece. And what's important to understand here is that this is nothing to do with 'evil' speculators, who will no doubt be getting the blame for all this again. Disingenuous politicians – just as they did in this country with HBOS – argue that Greece can't pay its debts, because speculators are profiting by driving up the country's interest costs.
That gets the causality entirely the wrong way round. The reality is that speculators (also known as 'the market') are driving up Greece's borrowing costs, because it can't pay its debts. The sheer brutal mathematics of the situation strongly suggest that Greece cannot hope to get out of its financial trap without renegotiating at least some of its debts. In other words, existing bondholders are going to have to take a haircut at some point.
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Anyone betting on that now, is just taking advantage of an underlying reality, the same as Soros profited from the fact that Britain couldn't hope to stick with ERM.
What will happen to the euro now?
So what happens now? Jennifer Hughes points out in the FT that up until the current woes, the euro had basically been trading like a version of the old Deutsche mark for years. In other words, after initial fears after its formation, traders began to see the euro as a strong currency backed by a tough Germanic central bank.
But now all the talk is of bail-outs and political splits. Even although "the euro could bounce higher as investors close Greece-related positions" (assuming there is a bail-out), there's little chance of a return to D-mark status in the longer term. "Investors are very unlikely, in the eurozone's current form, to take its unity for granted again and will price in some discount for this."
This makes sense. But it also seems to assume that Greece will be the end of the story. Trouble is, it won't. Portugal (which is a country I'm rather fond of, so I take no joy in writing this) has seen its ten-year borrowing costs hit fresh highs too. How long before the markets are demanding to see where Portugal's bail-out is coming from?
Indeed, Joachim Fels at Morgan Stanley has suggested that the end result of all this could be that Germany leaves the euro. MoneyWeek magazine's editor-in-chief Merryn Somerset Webb wrote about this scenario a few months ago (Why Germany should dump the euro). Essentially, Fels argues that the costs to a weak country of leaving the euro are far too high. But "seceding to revalue and introduce a hard currency is easier."
Why Germany would leave the euro
Why would the Germans leave? Simple. "The bail-out… sets a bad precedent for other euro area member states and makes it more likely that the euro area degenerates into a zone of fiscal profligacy, currency weakness and higher inflationary pressures over time." None of those things are appealing to the average German taxpayer.
Fels is basically saying that Germany might just get fed up of working with its more fragile neighbours, and will go it alone again. And without Germany to back it, the euro would increasingly look like just another basket-case currency. So while the euro's direction might be pretty volatile in the weeks to come, long term it could still have a very long way to fall.
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