What Will Save the Euro?

by: Cliff Wachtel

The US Real Estate Debt Crisis Was The Euro’s Best Friend Through Most of 2009-It Remains The Euro’s Best Hope For the Coming Months

As one who spends a lot of time watching and pondering forex markets, I’ve been asking myself what it would it take to turn around the dominant forex trend, the downtrend in the EURUSD pair. This single pair alone accounts for about a third of all forex trade, and the two currencies thus force each other to move in opposite directions like children on a seesaw. For example, for every 3 euros bought, a dollar must be sold, and vice versa. As the top 2 most widely held currencies, they profoundly influence commodity markets (priced in dollars) and every other asset market I can think of

Throughout the fourth quarter of 2009, when the USD was despised, I wrote about what kinds of conditions were needed to reverse the USD downtrend (summarize and note how soon it came true). I suggested that there were 3 ways the USD could rebound:

  1. Improved fundamentals especially in jobs and spending, or at least inflation, that would push the Fed to raise short term interest rates
  2. Some kind of fear-inducing phenomenon to spur a flight to safe-haven assets like the USD.
  3. Some kind of event/phenomenon that would undermine the EUR. Again, the two currencies force each other to move in opposite directions, so a crisis in the USD powered a huge EUR rally in 2009, and the opposite has occurred in 2010.

What actually did reverse the USD’s downtrend was the EU sovereign debt crisis, ignited by the Dubai default threat and fed by the exposed imminent Greek default threat. This phenomenon was a potent combination of factors 2 and 3 above.

Given that now the same utter despair surrounds the EUR, it's time to start thinking like a contrarian and ask the same question – what would turn around the EURUSD downtrend? Conceptually, the answer is just as simple as it was back then:

  1. Improving EU Fundamentals- One or a combination of the following:
    1. Progress towards a convincing EU endgame: Unlikely, given that credit markets are pricing in a 69% default probability in the coming 5 years at latest. That would likely cause at least a few others in its wake. Portugal has very heavy exposure to Greece, and the resulting fear could spike rates enough to drag a few others down.
    2. EU gives up, recognizes the inevitable, lets default occur and backstops key banks like the US did in late 2008-early 2009. Probability: Unlikely as this involves lots of short term pain, and politicians like to put off pain until at least the end of their term in office. Though it might be the cheaper long term solution, there is a legitimate argument that it’s better to buy time to find a solution, or at least an orderly default and/or EU breakup than bring on a sudden crash now.
    3. Genuine Growth: Unlikely, as no one expects this in the coming years with virtually every European government moving towards various degrees of austerity. This hurts GDP, and therefore the factors that tend to feed inflation (consumer and business spending growing faster than the supply of goods and services) in the short term.
  2. General Long Term Risk Asset Rally: Unlikely; The EUR’s higher yield has meant it tends to benefit from general market rallies. Risk asset markets are in a clear longer term downtrend, and indeed have been in one since the Summer of 2007. See Three Powerful Bearish Signs: S+P 500 Heading To Around 830, Short Risk Assets , How Far Could Markets Rally And Implications , and The Current Alignment Of Bullish And Bearish Forces for details.
  3. Some kind of event/phenomenon that would undermine the USD, thus boosting the EUR without any need for actual improvements in underlying fundamentals.

Considering the above alternatives, this is by far the least demanding alternative for the EU and thus seems the most likely hope for the EUR. That leads to the next question-what are the most likely factors that could undermine the USD?

The only likely type of event or phenomenon that would actually make the USD look as bad as, or worse than, the EUR would have to be something that undermines confidence in it even more severely than the sovereign debt mess does for the EUR. What could that be?

The essence of the EUR’s weakness is that the PIIGS undermine the EU banking system and economy, for it is the banks, especially the large ones of each nation that serve as the mainstay of credit and liquidity for each nation. The problem is that a Greek sovereign default ultimately threatens French, German, and other core EZ member nation banks, and thus their economies.

Yes, one can argue that any currency union without fiscal integration will lead to a similar end, but the immediate problem is lack of confidence in the banks.

Thus it’s reasonable to ask, what comparable threat exists for the US banking system? Now the answer is much clearer.

The Threatened US Real Estate Collapse Part II- The American PIIGS

As the risk of the PIIGS nations’ sovereign debt default threatens the EU’s banking system and economy, so does America’s bad real estate debt threaten the US financial sector and economy. The risk of a wave of mortgage defaults crashing US banks is truly ‘the American PIIGS.’

As you may recall, the US subprime real-estate lending crisis undermined confidence in the US financial sector, which caused the current global downturn, and introduced so many to the meaning of systemic risk. America bought time to heal itself via

  • The biggest bailout program in its history: That’s well known.
  • A temporary lull in mortgage refinancing: Less known but also important. The chart I’ve presented often before (hat tip to Graham Summers who presented it here), that illustrates how a lull in US mortgage rate resets is ending, and a new wave of similar size to that which sparked the original (aka subprime) crisis is upon us. This threatens a new wave of defaults that will once again undermine the US financial sector.

Obviously, much depends on at what rate these loans reset. The current risk aversion has helped keep benchmark 10 year T-bill rates low. However we don’t know how long that will continue with the US selling an average of $50 bln in debt per week. Last week’s 5 year bond auction’s bid to cover ratio was 2.58, very poor for this relatively short duration and even worse considering that the current downtrend in stocks, which should support demand for supposedly ultimate safe-haven US debt.

If there is anything that could potentially rival the EU sovereign debt crisis for global market impact and reverse the EURUSD trend, it’s the US Real Estate Debt Crisis, the one that set off the current Great Recession.

In sum, the best chance for a long term reversal or stabilization in the EURUSD is a relapse or double dip or utter collapse of the US housing market and ensuing banking crisis. A collapsing housing market and ensuing banking sector collapse would be the US equivalent of the PIIGS. Both represent a chronic drain on the host economies, capital, jobs and spending, with no end in sight, sucking their respective economies down into multi-year decline/loss of wealth.

Of course, whether or not the EUR or USD is doing better may not be so relevant.

If/when we get The US Real Estate Debt Crisis Part II, then unless the EU pulls off a minor miracle, a double dip recession will be a best case scenario, and a Great Depression becomes a distinct possibility (likelihood?) as the two prime economic blocks, the EU and US, pull each other down in the mother of all systemic collapses.

Disclosure: No Positions