The EUR/USD remains stuck in a downward trend. The Euro has had a tumultuous two years. After peaking at nearly $1.60 in the summer of 2008, it then plummeted 20% in a little less than 3 months as the financial crisis gripped the EU and it became clear that Europe’s banking sector was under considerable duress. As the market rally unfolded in early 2009, the EUR staged a rally up to $1.50, and has since been hijacked by the Greek drama and sold off to $1.36.
The fragility of the financial system
Given that Greece’s GDP is approximately US$ 356 billion (compared with Germany’s US$ 3,652 billion economy), the Greek debt crisis is not an insurmountable task for the EU. In fact, current talk is to help Greece meet its immediate obligations (20 billion EUR of its debt falls due in April and May) only. What the Greek crisis has shown the market is the fragility of the global financial system (much like the Dubai scare did in November of last year). Also clear are the deflationary pressures still circling through the global economy.
Further profligacy is feared
Clearly, either Germany or the EU can gather enough financial resources to bail out Greece. Most likely it will be a joint effort led by France and Germany, the country with the deepest pockets. But as the Economist said: “Berlin frets that a rescue will only encourage further profligacy”.
Why the markets got spooked
What is most at question now is the “common currency regime” of the Euro bloc. Combine the moral hazard problem of bailing Greece out, with bleak finances in the peripheral euro area, the small chance that the Euro bloc countries can maintain their fiscal responsibilities, along with the continuing economic contraction in Europe and you will understand why markets got spooked.
Where do we go from here?
After vague promises, markets want European finance ministers to come up with concrete measures. The issue at hand is whether the EU will finalize the details of support extended to Greece to prevent a default. Since January 22, markets have been seized by the ongoing concerns regarding Greek public finances though the S&P rallied back to 1,100 from a low of 1,040. Let’s put this in a global context:
- As we discussed on our blog post on January 26 ( click here to read ), Greece’s problems relate not only to an extraordinarily high debt load but a really ugly deficit problem as well: the debt to GDP ratio in Greece is near 125% and the fiscal deficit as a percent of GDP is near 12.5%.
- The ECB has not done as much as the Fed in reflating its economy: since 2008 M2 has expanded about 13% in the US, whereas in Europe M3 has expanded only 6%. Additionally the Federal Reserve’s balance sheet has grown by a multiple of 2.6x in the same time frame, compared with 1.4x in the Eurozone.
- Euro area authorities will find a way to bail out Greece and avoid the markets forcing the PIGS into a default scenario. PIGS refers to Portugal, Ireland, Greece and Spain. Note that since last week Greek rates have dropped from 7% to 6%.
In summary
We think evaluating the EUR move over the past two months has been fundamentally logical (the EUR is overvalued on a purchasing parity basis, combined with the Greek drama) as well as on a technical basis (DXY seemed to make a major market bottom this year). We think the EUR will drift lower versus the US$.
Good trading,
The Covert Analytics Team
