by Axel Merk at FT.com:
Imagine a country that spends and prints trillions to patch up any problem.
Now imagine another country where there is no central Treasury, meaning that bail-outs are less easy, and which has a central bank that has mopped up liquidity over the past year, rather than engage in quantitative easing.
Why does it surprise anyone that the latter, the eurozone, has a stronger currency than the former, the US? Because of peripheral countries’ debt refinancing issues? And the potential for contagion? These are real and serious issues, but in our assessment, they should be primarily priced into the spreads of eurozone bonds, not the euro itself.
Think of it this way: in the US, Federal Reserve chairman Ben Bernanke has testified that going off the gold standard during the Great Depression helped the US recover faster than other countries. Fast-forward to today: we believe Bernanke embraces a weaker currency as a monetary policy tool to help address the current state of the US economy. What many overlook is that someone must be on the other side of that trade: today it is the eurozone, which is experiencing a strong currency, despite the many challenges in the 17-nation bloc.
A year ago, the euro appeared to be the only asset traded as a hedge against, or to profit from, all things wrong in the eurozone. This was partly driven by liquidity, because it is easier to sell the euro than to short debt of peripheral eurozone countries; and as the trade worked, others piled in. As the euro approached lows of $1.18 against the dollar, the trade was no longer a “safe” one-way bet and traders had to look elsewhere. As a result, the euro is now substantially stronger, yet peripheral bond debt is much weaker.
The one language policymakers understand is that of the bond market. A “wonderful dialogue” has been playing out, encouraging policymakers to engage in real reform. Often minority governments have made extremely tough decisions. Ultimately, it us up to each country to implement their respective reforms; political realities will cause many to fall short of promises, resulting in more bond market “encouragement”. Policymakers hate this dialogue, of course, but must respect it.
Any country may default on its debt. The problem is that it may be impossible to receive another loan, at least at palatable financing costs. Any country considering a default must be willing and able to absorb the consequences, which is an overnight eradication of the primary deficit.
That’s why it is in Greece’s interest to postpone any debt restructuring until more reform has been implemented.
The risk/reward consideration of a default is likely to be more favourable a few years from now. The banking system has already had time to prepare for a Greek default, among others, unloading securities to the European Central Bank. Politics may cause an earlier default, but Greece would be shooting itself in the foot, as an important incentive for further reform through the carrot and stick approach of the European Union and International Monetary Fund is taken away. Moreover, why refuse the easy money?
Debt reduction in principle is certainly possible. Belgium in the 1990s had a debt to gross domestic product ratio of about 130 per cent and has since taken it down to about 98 per cent. The Belgium caretaker government appears easily capable of continuing the country’s prudent fiscal path.
Portugal’s main challenge is that it is a small country with a weak government, but it is capable of living up to its commitments.
Spain is a major country that has had a housing bust – nothing new in modern history. Given Spain’s low total debt to GDP and an assertive approach to overhauling its banking system, we sometimes compare Spain to Finland. In the early 1990s, Finland had a housing bust, as trade with the Soviet Union ended, followed by a banking system implosion and soaring unemployment. Both Finland then and Spain now have low debt-to-GDP ratios. It may be easier to implement reform in Finland (and Finland had a free-floating currency), but Spain has a real economy and ample resources.
Ireland is trickier, because a default may be an attractive political consideration. However, we would be more concerned about fallout to sterling, given the exposure of the British banking system, than the euro.
In the US, the day investors come to accept the reality that inflation, rather than fiscal discipline, is the path of least political resistance may be the day the bond market won’t be as forgiving. Unlike the eurozone, where consumers stopped spending and started saving a decade ago, the highly indebted US consumer may not be able to stomach higher interest rates. The large US current account deficit also makes the dollar more vulnerable to a misbehaving bond market than the eurozone.
In the medium term, we are far more concerned about risks to the US dollar than those posed by the Greek drama to the euro.
Axel Merk is president and chief investment officer of Merk Investments
Imagine a country that spends and prints trillions to patch up any problem.
Now imagine another country where there is no central Treasury, meaning that bail-outs are less easy, and which has a central bank that has mopped up liquidity over the past year, rather than engage in quantitative easing.
Why does it surprise anyone that the latter, the eurozone, has a stronger currency than the former, the US? Because of peripheral countries’ debt refinancing issues? And the potential for contagion? These are real and serious issues, but in our assessment, they should be primarily priced into the spreads of eurozone bonds, not the euro itself.
Think of it this way: in the US, Federal Reserve chairman Ben Bernanke has testified that going off the gold standard during the Great Depression helped the US recover faster than other countries. Fast-forward to today: we believe Bernanke embraces a weaker currency as a monetary policy tool to help address the current state of the US economy. What many overlook is that someone must be on the other side of that trade: today it is the eurozone, which is experiencing a strong currency, despite the many challenges in the 17-nation bloc.
A year ago, the euro appeared to be the only asset traded as a hedge against, or to profit from, all things wrong in the eurozone. This was partly driven by liquidity, because it is easier to sell the euro than to short debt of peripheral eurozone countries; and as the trade worked, others piled in. As the euro approached lows of $1.18 against the dollar, the trade was no longer a “safe” one-way bet and traders had to look elsewhere. As a result, the euro is now substantially stronger, yet peripheral bond debt is much weaker.
The one language policymakers understand is that of the bond market. A “wonderful dialogue” has been playing out, encouraging policymakers to engage in real reform. Often minority governments have made extremely tough decisions. Ultimately, it us up to each country to implement their respective reforms; political realities will cause many to fall short of promises, resulting in more bond market “encouragement”. Policymakers hate this dialogue, of course, but must respect it.
Any country may default on its debt. The problem is that it may be impossible to receive another loan, at least at palatable financing costs. Any country considering a default must be willing and able to absorb the consequences, which is an overnight eradication of the primary deficit.
That’s why it is in Greece’s interest to postpone any debt restructuring until more reform has been implemented.
The risk/reward consideration of a default is likely to be more favourable a few years from now. The banking system has already had time to prepare for a Greek default, among others, unloading securities to the European Central Bank. Politics may cause an earlier default, but Greece would be shooting itself in the foot, as an important incentive for further reform through the carrot and stick approach of the European Union and International Monetary Fund is taken away. Moreover, why refuse the easy money?
Debt reduction in principle is certainly possible. Belgium in the 1990s had a debt to gross domestic product ratio of about 130 per cent and has since taken it down to about 98 per cent. The Belgium caretaker government appears easily capable of continuing the country’s prudent fiscal path.
Portugal’s main challenge is that it is a small country with a weak government, but it is capable of living up to its commitments.
Spain is a major country that has had a housing bust – nothing new in modern history. Given Spain’s low total debt to GDP and an assertive approach to overhauling its banking system, we sometimes compare Spain to Finland. In the early 1990s, Finland had a housing bust, as trade with the Soviet Union ended, followed by a banking system implosion and soaring unemployment. Both Finland then and Spain now have low debt-to-GDP ratios. It may be easier to implement reform in Finland (and Finland had a free-floating currency), but Spain has a real economy and ample resources.
Ireland is trickier, because a default may be an attractive political consideration. However, we would be more concerned about fallout to sterling, given the exposure of the British banking system, than the euro.
In the US, the day investors come to accept the reality that inflation, rather than fiscal discipline, is the path of least political resistance may be the day the bond market won’t be as forgiving. Unlike the eurozone, where consumers stopped spending and started saving a decade ago, the highly indebted US consumer may not be able to stomach higher interest rates. The large US current account deficit also makes the dollar more vulnerable to a misbehaving bond market than the eurozone.
In the medium term, we are far more concerned about risks to the US dollar than those posed by the Greek drama to the euro.
Axel Merk is president and chief investment officer of Merk Investments
