Over the last 10 years, I have followed--sometimes in awe, sometimes in confusion--the evolution of the main European currency: the euro.
For about 8 years, despite all odds and many economists’ fears, the euro seemed to be a success. The current sovereign debt crisis, which started at the periphery of the euro zone with a relatively small economy like Greece’s, brings forward again questions about the viability of the euro.
Where is this currency headed – break-up or on-going use? And if it will continue to exist, where is it going to end against the world's other currencies and most importantly against the dollar.
First, let’s take a look at the euro’s short history. After its official introduction in 2001, the euro traded for about 1-1 1/2 years within a relatively tight range against the dollar before the American currency started what seemed like an unabashed descent.
While the current trading range for the euro is 5-10% lower when compared to several months ago, it is still significantly lower than where it was for most of the euro’s lifetime (average exchange rate for the euro’s life is 0.807 USD/Euro).
As time went on, the euro became the second most important world currency and in 2006 - 2007 it was even expected to gradually assume the dollar’s role as the world’s main reserve currency ( according to IMF speeches and studies during ‘06/’07 as well as Greenspan’s speech in September 2007). It currently represents over 30% of the world’s currency reserves and, out of the top 20 largest GDP countries, five actually use the euro.
Since the European sovereign debt crisis started, the euro has not weakened significantly against most currencies including the dollar, failing to incorporate the sovereign debt threat and the macro risks associated. Whereas the CDS spreads have more than doubled since the beginning of the year, the euro has experienced just a slight adjustment and that only recently. Even though the euro countries seem for the moment committed to holding onto both the euro and Greece, doing everything to support them, there are numerous risks to the euro, some of them threatening the very existence of it:
- The European rescue fund (somewhat bombastically christened EFSF) mechanism cannot cope with Italy and Spain. The 440 billion euro fund currently available in the EFSF is in reality significantly reduced by all sorts of guarantees and cash reserves and will not be sufficient for Italy and Spain in a real crisis scenario. It is estimated that Italy and Spain need over 700 billion euro funds during 2012-2014, including rolling the existing debt and interest payments. Both countries are also part of the EFSF guarantors so they would need to pitch in themselves for any rescue and assume EFSF guarantees, further complicating the process and increasing the funds needed. (Source: Eurostat, EFSF).
- Public finances are over-stretched ALL across the euro-zone. The main guarantors of the EFSF mechanism are Germany and France, which are both highly levered even when compared to the US. In the excitement over the growth of the German economy in the last few years, markets seem to have forgotten that public debt in Germany is at more than 83% of the GDP, slightly above that of France at 82.4%. Most of the other participants in EFSF are in high debt themselves including Greece, Portugal and Italy holding the sad record of top indebted nations in the world and some of the others like the Netherlands and Austria have their own high levels of Debt to GDP at 63% and 71% respectively. (Source: Eurostat).
- Poor leading economic indicators are exacerbated by the current credit crunch – The purchasing managers’ index for euro zone manufacturing has dropped sharply this year and is down over 5% in August. The banks’ deposits in the euro zone have decreased substantially and combined with the increased cost of funding will reduce the banks’ ability to fund themselves and will contribute to overall slower economic activity, putting the brakes on GDP growth.
- Monetary loosening combined with fiscal tightening will dampen economic growth. Under the current circumstances and with significant liquidity events in Italy and Spain until 2012, the solution of the Euro bonds, as unpalatable as it may be to Germans, may offer a viable short term way out. A rate cut, which in my view has a high probability after the last ECB meeting, may push the monetary loosening even further. Eurobond issuances and/or an interest rate cut will help flare inflation at a time when fiscal policies are tightening. A rigid fiscal atmosphere is likely to slow business activity growth and depress employment levels even further from where we are today.
Despite the macroeconomic and political risks increasing, the euro currency is getting to implausible stronger levels. Even if in, what now seems a very unlikely scenario, the Greece sovereign crisis will be solved in an organized way and Greece will stay in the euro area, the euro should remain under pressure and go up closer to its historical average against the dollar.
Though the euro may be strengthening on a wave of liquidity for now and possibly in the short term, I would expect it to go significantly down in the next six months to one year. I have shorted the euro will come out of the trade once it reaches 0.80 USD/Euro.
For investors that are not trading currency or currency options, there is also a liquid euro short ETF called ETF ProShares Ultrashort Euro (EUO) which is trying to replicate the daily movements of the Euro with a 2x leverage.
Disclosure: I am short the euro.