Seeking Alpha
Hedge fund manager, portfolio strategy, momentum, contrarian
Profile| Send Message|
( followers)  

Summary

  • The Russian military build-up on the Ukrainian border is cause for concern.
  • Less EU resistance to monetary easing opens the door to increased euro supply.
  • EU vs US. US economy growing faster, but this week's data will confirm.

The Russian military build-up on the Ukrainian border

Political analysts are right now trying to predict Vladimir Putin's next move. The western world's intelligence agencies completely failed to forewarn of the Russian military build-up on the Crimean/Russian border during the Maidan protests, and the Russian forces rolled into Crimea completely unhindered, militarily or politically. Even before this land grab, it was widely acknowledged that Putin had grandiose ideas of returning Russia to its former Soviet Union power and glory. Many Russians hold nostalgic and fond memories of the Soviet Bloc and remember how it inspired respect and fear by the rest of the world. The decline of the superpower is thought to be a humiliating event that can be corrected by Russia again exerting its power and reclaiming its sphere of influence. We might now be led to believe that Putin and his inner circle generally concur with these sentiments. The Russian takeover of Crimea is a conversion of this doctrine into action. Perhaps the Russian invasion of Georgia didn't inspire this Soviet renaissance revelation in the western world in 2008, however, with the current massive Russian military build-up on the Ukrainian/Crimean border, Russian expansionist intentions have many international agencies worried, if not panicked. NATO, in particular, must be fretting a great deal.

According to the latest reports, there are up to 100,000 Russian soldiers on the Ukrainian border, with military field hospitals currently being erected and hot food packages being delivered to forward units. Russia claims that these troop movements are simply for military exercises, and Russian FM Lavrov has pledged that Russia would not invade mainland Ukraine. However, intimidating demands have been made of the new Ukrainian government that are likely to be rejected, such the insistence that it not join NATO in the future. Russia also continues to stress that it reserves the right to defend the lives of Russian speakers and compatriots in foreign countries unilaterally. Eastern Ukraine is mostly populated by ethnic Russians.

It seems that there is substantial international and economic pressure on Russia that it back down from its belligerent stance, although we can assume that Crimea has been sacrificed. Putin actually called Obama to discuss ways to de-escalate the crisis and reduce the tension, and soothing Russian diplomatic overtures have reduced European and American anxiety.

Yet, independent European countries have not been lulled into a false sense of security. Many rightfully believe that if there were a reduced level of international pressure, Putin would possibly have troops in Kiev right now, and those skeptical of Putin's intentions believe he would probably invade if he could get away with it, even at the expense of sanctions and a short but severe economic slump. Perhaps with these calming overtures, Russia is just testing international resolve to defend Ukraine or to add an element of surprise in case it does decide to attack. However, until it actually removes military units from the border, it would appear that Russia is poised to invade. According to Russian military analyst Pavel Felgenhauer, the next six weeks "are a prime period for an invasion". The Russian disregard for a foreign country's territorial integrity has already been proven.

The facts on the ground advise us that Russia is looking to invade Ukraine, or at least occupy and/or annex Eastern Ukraine, and that troops are not simply placed on the border to defend the newly-acquired Crimean territory. With this in mind, we should expect the most severe European crisis since 1945, though perhaps we should not automatically assume there will a military confrontation between Western forces and Russian forces, we can presume that there will be massive economic upheaval in Russia and the tied eurozone.

The most obvious casualty of this crisis will be the euro and the ruble. Russian commodity exports, such as crude oil and natural gas would be hit severely, and we can expect the stock markets of all those in the region to tumble dramatically. The EUR/USD will fall as funds take flight to safe havens such as Switzerland or Sweden, and exports between the large trading partners dry up. (perhaps the market might be currently pricing in this real possibility as the tensions rise). How far the EUR/USD could fall based on this market shock alone is anybody's guess, but a drop to the strong support level of 1.20 is realistic.

Less EU resistance to monetary easing

The European Central Bank could buy loans and other assets from banks to prop up the eurozone economy. This affirmation by the hawkish Bundesbank marks a shift in its stance against quantitative easing, a hotly contested European policy. The effect of this economic policy would drive the euro lower, increasing exports, but it might also increase inflation. Currently, economists are worried about deflation, driven by cheaper imports and falling demand for products. Eurozone inflation now sits at 0.5%, while the EU inflation target is 2%. The ECB will not want to decease the 0.25% interest rate, as it already stands at a record low and it does not give the Eurozone much room to maneuver should further cuts be necessary, however, various ECB members have stated they are willing to take action, if necessary. The president of the German Central Bank, Jens Weidman stated last week, "For now, there was no need to act, but if the outlook for inflation changed, for example as a result of a stronger euro exchange rate, the ECB could step in, most likely with another interest rate cut, and possibly even QE."

In a related comment, European Central Bank President, Mario Draghi has also weighed in on an expensive euro earlier in March. He has sounded caution on recent euro gains, and ECB members have specifically suggested that an exchange rate over 1.40 is too high. In this regard, a view on a lower EUR/USD exchange rate is more realistic.

Europe vs. US. US economy is marginally growing faster

Although both economies are undoubtedly regaining strength, albeit at a slower rate than desired, it appears that new economic data coming from the eurozone is less encouraging than from the US. Unemployment and consumer confidence data from the US is mostly positive, while German manufacturing is down and consumer confidence is not as strong. Besides the statistics, the sentiment in the market is that US economy is growing faster than expected, while the EU zone is growing at a lacklustre rate. The Fed chairwoman, Janet Yellen, even suggested that US interest rates could rise in the spring of 2015. Despite this, it is important to point out that many economists believe the US recovery may be artificial and due to the economic stimulus not filtering though to the real growth sectors of the American economy and the general population. Later this week, we have important data coming out and we should gain a better picture of the economic climate of both regions. The ECB press conference on Thursday will be an important release.

(click to enlarge)

(click to enlarge)

Source: The Case For A Much Lower EUR/USD Exchange Rate