- The eurozone is stuck into low or even negative growth on the border of deflation.
- Yet the ECB balance sheet has shrunk, this will not last as the risks are increasing.
- Risks are a deflationary shock from the Russia crisis and tightening US monetary policy.
- The euro will also suffer from a flight into the dollar as a result of its safe haven status in times of international crisis.
As we've been arguing for some time, the eurocrisis hasn't gone away, it's merely reappearing in another manifestation.
There has been a eurocrisis mark I, in which curiously the euro itself was rather strong but peripheral bond markets were gripped with panic. Once the European Central Bank (ECB) promised to "do all it takes" to serve the euro, that phase finished.
But underlying problems weren't really fixed and we're now entering eurocrisis mark II, in which the euro will sell off.
Eurocrisis Mark I a brief recap
We used to have panic selling of bonds from peripheral eurozone countries (Ireland, Greece, Portugal, Spain, Italy) because of a phenomenon which is known to economists as 'multiple equilibriums.' This pointed to a situation in which bond yields can become unstable and be subject to self-reinforcing feedback loops
That is, without a lender of last resort (eurozone countries effectively borrow in a foreign currency over which they have no control), once bond markets spot danger in the public finances, a sell-off starts, producing a larger sell-off.
You have to understand the specifics of a common currency here. Compare that to a situation of a country which is master of its own currency, like the UK. If the UK bond market sells off, investors sell bonds and receive pounds.
If they don't like other UK assets, they'll sell those pounds, but these are bought by other investors and these put it into UK assets (bank accounts, bonds, stocks, whatever). That is, these pounds never leave the country.
Compare that to a selloff in Spanish bonds. The seller receives euros, which he or she can reinvest elsewhere in the eurozone (for instance, in German bonds, bank accounts, etc.). That is, the money leaves the country.
You might have spotted a couple of crucial differences:
In the UK, a bond sell-off also has a tendency to depreciate the currency, partly offsetting the deflationary effects of higher bond yields. There is no such stimulating depreciation when investors sell Spanish bonds.
In the UK, the money stays in the UK while in Spain much of it leaves the country at no cost or risk (eliminated by the common currency), producing a further deflating effect by contracting the money supply.
These differences already created something of a negative feedback loop in countries like Spain, as a sell-off in its bonds worsened economic conditions, which worsened public finances and bank balances, which led to more selling and capital leaving the country, etc..
And there is a third crucial difference. Since the UK issues debt in its own currency, it can always pay it back by issuing new currency. This isn't the case in Spain (or any of the other eurozone countries), because that's dependent on the ECB.
So, Spanish (and Greek, Italian, Portuguese, Irish) bonds were subject to real default risks, while countries like the UK (at the time) and Japan had equally bad (or even much worse) public finances without bond markets panicking.
Enter the ECB
Enter the ECB, which in 2012, after another peripheral bond market panic, argued that it was prepared to "do all it takes" to save the euro, implicitly taking upon it the task of lender of last resort, as almost any other central bank in the world.
There were conditionalities attached to ECB rescue, but they (so far at least) never had to be invoked as the mere announcement was sufficient to gain credibility in the markets and peripheral bonds started a long rally.
For a while, this seemed to have saved not only the day, but the whole eurocrisis. Lower bond yields meant cheaper financing for peripheral eurozone countries, which has the potential to increase the quality of their public finances. Some countries, like Ireland and Portugal, even returned to the markets after they had to be bailed-out earlier because market rates were simply too high.
Eurocrisis Mark II
But underlying economic conditions didn't really improve, more especially, peripheral countries (and even some core countries) suffered from:
Negative or low growth
Negative or low inflation
Despite all the austerity efforts and the steep falls in bond yields the combined effect of low or even negative growth and inflation produced a 'denominator' effect, sharply increasing public debt/GDP ratios because of stagnant GDP.
We have already singled out Italy in this respect, and the picture is getting more scary by the day, now that Italy has fallen back into recession. But Italy is hardly the only eurozone country suffering from the denominator effect:
And now the risks are compounding:
In the US, Fed bond purchases are phased out by October and economic figures have increased the chances of interest rates going up.
Even in Germany, growth is stalling
Russia is retaliating the sanctions and this is a crisis that has the potential to get significantly worse
The ECB seems paralyzed, its balance sheet has sunk by over a trillion since 2012
A considerable part of the EU is already experiencing deflation (see graph below)
Sell the euro
The shrinking ECB balance sheet is especially perplexing, given the circumstances and the risks we just featured above. But now that these are increasing it seems likely that the ECB will act sooner rather than later.
The risk from an escalation of the crisis with Russia has the potential to deliver several blows, like:
Shares in German sportswear giant Adidas have fallen to two-year lows after the company slashed its projected earnings, citing financial uncertainty in sanction-hit Russia. European markets struggled in general. [DW]
Adidas will hardly be the only company that suffers a Russia shock, especially now that Russia is banning agricultural exports from countries (including the EU) embarking on sanctioning Russia.
The whole crisis with Russia has the potential to sink bigger parts of the eurozone into recession and/or deflation and we've already explained what that will do for the health of their public finances.
Since EU trade with Russia is much bigger than the trade between the US and Russia, the EU, and by extension the euro have the potential to suffer much more as a consequence of a wider EU-US growth differential.
While it is difficult to argue that the euro is overvalued (as a whole, it has a fairly substantial trade surplus), what is certain is that many peripheral countries are very uncompetitive versus Germany. Despite terribly depressed domestic economies, they hardly manage to generate trade surpluses.
Most of this is the result of the euro itself as these countries experienced large capital inflows due to the disappearance of exchange rate risk. These capital inflows produced accumulating inflation differentials with the core countries, that is competitiveness worsened and large trade deficits were the results.
A general euro depreciation isn't much help here, as it leaves the intra-euro competitive positions unchanged, but it would bring a mild relief boosting some growth and import prices, reducing the denominator effect somewhat.
One also has to realize that the dollar has a habit of functioning as a safe haven investment in times of international crisis. Indeed, it's the second cheapest hedge, according to ZeroHedge:
So, we summarize the reason for being bearish on the euro:
Much of the eurozone is mired in low to negative growth and inflation
Even German growth is decelerating
Low or negative growth and/or inflation ravages public finances
The growth differential with the US is growing
The Russia crisis is likely to exacerbate this
US monetary policy is tightening
Eurozone monetary policy is likely to be loosening
The dollar gains in times of international crisis
The funny thing is, betting against the euro would actually help the eurozone, at least somewhat.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: We're Short EUR/USD