The Importance Of The IMF And European Treaties On The EUR/USD

Includes: ERO, EU, FXE
by: Douglas Borthwick


Nuts are cracked by placing them on a firm surface, and then hitting them with a hammer.

In the European debt crisis, the nuts are individual sovereigns. The hammer is the market and either the IMF or the ECB need to be the firm surface. Current treaty limitations are prohibiting the ECB from taking this role, while the IMF cannot take it on for so long as there is (1) Lack of US Congressional support for a European bailout via the general fund, and (2) An inability for the Bundesbank and other national central banks to lend to a segregated 'trust' within the IMF marked solely for European use.

Consistent pressure on European sovereigns is needed in order to push them towards accepting fiscal reforms as set forth by the European Union. Initially, the plan was to have market yields push sovereigns into reform. If they were not moving fast enough and market yields reflected that, then they would have had the option of borrowing from the IMF at more acceptable rates. However, the IMF would then impose fiscal reform on the European sovereign. Either way, European sovereigns would have (1) continued to have access to funding and (2) been cajoled into adopting widespread fiscal reform as demanded by the European Union in order to achieve European Fiscal Union.

The European Central Bank problem

As noted by the ECB's Draghi earlier today, treaties prohibit monetary financing by the ECB. In addition, the ECB cannot lend directly to the IMF because it is not a 'member country'. For this reason national central banks within Europe need to lend directly to the IMF if they wish to create a fund that would act as the 'lender of the last resort.' However, the German Bundesbank noted on Tuesday that they would only contribute to the general fund and would not lend into a Eurozone 'trust' because European treaties prevent such action. In order for the Bundesbank and other national central banks to be able to offer bilateral loans to the IMF for a European bailout, treaties need to change. Unfortunately for the Eurozone, it is looking like treaty changes will not be announced until March of 2012.

The IMF Problem

Without creating a separate 'trust' devoted to the Eurozone bailout, any monies directed towards Europe will come under the scrutiny of the US Congress. As the GOP leadership stated yesterday, the US and the US Federal Reserve have no plans to increase IMF funding to bail out Europe.

A Stop-Gap Solution

Last Friday, Christine Lagarde said that the IMF would take 10 days to come up with a European Plan. We are waiting to see this plan. It could be one where she creates a 'trust' segregated from the general fund that allows non-European countries to initially fund. This would be joined by European Central Bank Funds following treaty changes in March. Yesterday, Dutch officials stated they believed a European bailout fund could reach 1 trillion EUR. It is notable that the Bundesbank also stated they would only contribute to the IMF if other nations did too. I first dismissed this conditionality, but it now makes sense if Lagarde's plan is to create this stop-gap solution. The Bundesbank was stating that it would only up their IMF contributions if other countries did too.


For as long as there is no announced workable plan from the IMF I will be negative on the EUR/USD, as we have been since 1.3200. Without being forced to reform, European sovereigns will likely languish in indecision. However, should Lagarde and the IMF announce a 'trust' segregated from the IMF general fund, immediately funded by non-European countries, with an expectation that European country funds will be diverted into it following Treaty change in March, then that is a plan that would bring back my support for the EUR/USD. It is a plan that in my mind would have the sufficient 'lender of the last resort' firepower that would bring stability to the region, stability that is needed during the time of fiscal transition for European sovereigns.

Without a 'lender of the last resort,' European yields will rise to the point of default. However, yields will drop considerably if the market is comfortable with the knowledge that European sovereigns will be able to borrow, and be fiscally directed by the IMF. Such a plan will likely bring back Chinese confidence in the Eurozone, and this would be expressed through their fixing the USD/CNY lower. With that the USD/Index would retreat from recent highs. Until then, China's soft-peg will likely continue, the DXY will likely rise, and commodities and US equity markets will likely remain under pressure. The future of the EUR/USD is now in Lagarde's hands.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.