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Euro in 2011 – Time to Write an Obituary?

Last updated 12/29/2010 7:16 AM ET (GMT -5) 0 Comments - Add your comment

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Boris Schlossberg

Director of Currency Research, GFT

Euro in 2011 – Time to Write an Obituary?

As 2010 drew to a close, no currency was more reviled that the EUR/USD which faced severe selling pressure for most of the year as investors grew increasingly concerned about the sovereign debt financing woes of the region’s peripheral economies.  First Greece, then Ireland came under selling assault of the shorts and both countries ultimately required a bailout package from the EU in order to remain solvent. Yet despite what at times looked like a-crisis-a-day atmosphere, the EUR/USD ended the rollercoaster ride of 2010 essentially unchanged as fears over the persistent problems in the periphery were offset by surprisingly robust performance from the core economies of Germany and France. As 2011 looms ahead the euro may face its greatest challenge yet if the contagion spreads to the Iberian Peninsula and specifically Spain which is the fourth largest economy in the union. A sovereign debt crisis in Spain could overwhelm the monetary union and   stress the whole concept of the single currency to the point of fracture. However, despite these well known problems it is too soon to write an obituary for the EUR/USD. The euro after all was a political as well as an economic concept and the geo political considerations may ultimately prove to be the saving grace for the currency.

A Tale Of Two Europes

Perhaps nothing better encapsulated the schizophrenic nature of the Eurozone economy in 2010 than the following statistic – the unemployment rate for the Eurozone as whole rose to a decade high 10.2% while the unemployment rate for Germany, the region’s largest economy, declined to a two decade low. This dichotomy between core Europe comprised of Germany and France and other North European economies versus Southern Europe led by increasingly troubled Spain was the central story of 2010.  The German economy, driven by its booming export sector that thrived by supplying sophisticated capital goods equipment to Asia and Middle East, continued  to improve as the year progressed. In fact the German IFO institute survey of business executives – an important measure of business sentiment - hit all time highs as the year came to a close. The rise in optimism led many forecasters to increase estimates for 2011 GDP growth to nearly 3% up from 2.1% in 2010. Even the notoriously tightfisted German consumer began to loosen his purse springs in the second half of the year with Retail Sales rising an impressive 2.7% by November.  If this trend in consumption continues to improve contributing to an already booming production sector, the prospects for strong German growth in 2011 look increasingly positive.

Meanwhile in Spain the situation looks considerably more bleak. The country continues to suffer from the aftereffects of a massive real estate bubble with many Spanish banks still carrying dangerously high levels of nonperforming loans on their books. The unemployment rate in the country remains at a staggering 20% and most of the PMI indices continue to hover below the 50 boom/bust level. Despite these setbacks Spain has managed to avoid the type speculative assault on it sovereign debt markets that forced both Greece and Ireland into the accepting rescue packages from EU. Part of the reason for Spain’s relative strength is the fact that the size of its sovereign debt as percentage of GDP is just slightly above 50% - considerably less than the other periphery members of EU. However, Spain’ defense of its credit has come at a cost. Although auctions for its short term debt remain well subscribed with bid to cover ratios well above 2.0, the country has had to pay a steep price in interest rates. It’s most recent 6 month T bill auction went off at 2.6% - more than 200 basis points higher than the benchmark German bonds. Furthermore as 2010 was coming to a close the Moody’s bond ratings agency noted that it may downgrade Spain citing the country’s challenging refinancing needs in 2011. Moody's said in a statement that the Spanish government will need to raise approximately EUR170 billion next year. In addition, regional governments have refinancing needs of around EUR30 billion in 2011. "Moreover, the Spanish banks, whose own funding capacity partly depends on the fortunes of the Spanish sovereign, have around EUR90 billion worth of term debt to refinance in 2011," Moody's added. This massive overhang of Spanish debt presents the single greatest danger for the EUR/USD in 2011.  If Spain is unable to refinance its debt obligations in the credit markets at reasonable rates, the EU will have no choice but to act as the lender of last resort in order to maintain the monetary union. However at more than $1 Trillion GDP, Spain’s economy dwarfs that of Greece and Ireland and its massive refinancing needs may be too large for the EU to bear.

German Economy Remains Key

Perhaps the greatest EUR/USD irony of 2010 was the fact that the one member that benefited the most from a unified currency was also the most reluctant supporter of the whole euro project.  Germany, which enjoyed a robust recovery from the depth of the 2009 recession in no small part due to lack of exchange rate competition, was also the most vociferous critic of the various bailout  plans put forward last year. German producers benefited mightily from their ability to institute uniform pricing standards in both intra-European and global trade due to a single currency standard. However, German citizens as whole were generally opposed to the rescue schemes designed to help keep the periphery economies afloat viewing the whole process as nothing more than a glorified transfer payment.  Chancellor Angela Merkel faced stiff political opposition, but was able to bulldoze through the bailout proposals only because of generally positive economic conditions at home. That’s why the German economy could prove pivotal to EUR/USD support in 2011. Not only is German growth important to the GDP performance of the overall Eurozone but continued robust expansion in Europe’s largest economy should also make it more palatable for its citizens to consider additional contributions to the Eurozone stability fund. Without the political support of Germany, which in turn is predicated on economic expansion, the EUR/USD faces an insurmountable crisis of confidence. Therefore in 2011 the mantra of the currency markets may well be - as Germany goes, so goes the euro.

ECB - What Happens When Trichet Leaves?

The one pan-European institution that could help stabilize the EUR/USD - the ECB has been remarkably mute throughout most of 2010.  ECB Chief Jean Claude Trichet has consistently dismissed the idea of a EZ break up as “absurd” while at the same time putting  responsibility on any bailout plans squarely on the shoulders of the region’ s fiscal officials. The ECB has continued to provide liquidity to the market by extending its unlimited tender offer through April of 2011, but so far has restrained from any truly aggressive actions such as implementing a QE program like the Fed. Part of the reason for the central bank’s reluctance to act is its strict mandate to maintain  price stability. To that end the ECB has kept rates steady at 1.00% and has communicated decisively that it intends to maintain them at record lows for the foreseeable future keeping monetary policy moderately accommodative.

In October 2011 Jean Claude Trichet will complete his term as the ECB President a position which he held since 2003. Love him or hate him, Mr. Trichet has been unquestionably a strong stabilizing force for the EUR/USD. With his Gallic sense of self assurance Mr. Trichet has been an unequivocal voice of consistency and support for the euro project throughout his tenure and has generally displayed a strong sense of pragmatism that has allowed the currency to gain tremendous legitimacy during his term in office. Mr. Trichet will leave the Presidency of the ECB as the second most powerful monetary official in the world and the leadership void that follows in his wake could create further volatility in the EUR/USD especially if he is succeeded by the Bundesbank President Axel Weber who is considered to be a much more doctrinaire policymaker.

China to the Rescue?

Despite the ominous forces arrayed against the euro in 2011, the single currency is not doomed to failure as many euro skeptics argue. One surprising source of support can come from China. As the year came to a close Chinese vice-premier Wang Qishan said his nation had taken “concrete action” to help the EU with its debt problems. With more than $2.5 trillion (£1.6 trillion) of foreign reserves, China is the one actor on the global economic stage that could stop the euro’s slide dead in its tracks.

Why would China want to help the EU? Simple. It has both economic and political reasons to do so. The EU is China’s largest trade partner and China is the region’s second-biggest export market, with bilateral trade increasing more than 33 per cent in the past 11 months to November from a year earlier.

Yet political considerations may be even more important than the economic concerns. As a rising global power, China is loath to see a return to a unipolar world with the dollar again the only medium of exchange for trade. Therefore the Chinese are likely to do everything in their power to preserve the euro as a viable alternative to the buck.  That in turn could mean that China may shift some of its reserves from US Treasuries to the sovereign bonds of the European periphery economies.  China has already been shifting its portfolio out of long tern US bonds towards much shorter duration Treasury bills providing it with the flexibility to shift assets on the fly if Spain or Portugal find themselves in difficulty next year.

Conclusion

As we enter 2011 sovereign debt concerns continue to be the dominant trading theme in the EUR/USD. For euro bears who have always argued that the concept of a currency without a country was doomed to failure, 2011 may prove to be the year when that thesis is finally put to a test. The turmoil caused by the credit crisis in Greece and Ireland is likely to have been only a preview of greater volatility to come. Spain remains the elephant in the room and its massive refinancing needs in 2011 could threaten to unravel the whole euro project if credit markets balk at purchasing its sovereign debt. However, these concerns are well known and with vast majority of speculators aligned against the EUR/USD its unlikely that the pair will maintain its one way down move in an uninterrupted fashion. What is relatively certain is that the price action in the EUR/USD in 2011 will continue to be driven by the credit markets. To that end, both the economic performance of Germany and the political commitment of China may prove to be key. If the EZ credit markets are unable to stabilize the EUR/USD could revisit its 2010 lows of 1.1900 and may even tumble towards the 1.000 level as the credit crisis turns into wholesale panic. However, if credit spreads begin to compress as investor concerns ease as the year progresses,  the EUR/USD could rally back to 1.4500 level as the risk trade makes a comeback in the currency market.

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About The Author

Boris Schlossberg began his Wall Street trading career more than 20 years ago at Drexel Burhnam Lambert. There, he traded nearly every type of financial product on the market in the U.S., from equities and options to stock index futures and foreign exchange. His innate ability to analyze market information and use it to trade has helped him become an industry-recognized, “go to” trading professional.

These days, whenever the markets move, many organizations turn to Schlossberg for his take on the situation. He is a weekly contributor to CNBC's Squawk Box and a regular commentator for Bloomberg radio and television. His daily currency research is widely quoted by Reuters, Dow Jones and Agence France Presse newswires and appears in numerous newspapers worldwide. Schlossberg has written for publications like SFO magazine, Active Trader and Technical Analysis of Stocks and Commodities. He is also the author of Technical Analysis of the Currency Market and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Kathy Lien. He joined GFT in 2008.