Reflexive Situation in the Euro
The New Consensus in the euro may be setting up the euro for a big downward price spiral.
But this isn’t the entire story. The reaction to the recent downgrade of France shows us something unusual about the price action in the EURUSD. There are reasons to believe lower levels in the euro will be self-reinforcing –lower EURUSD levels will tend to push the EURUSD even lower.
This is called a reflexive situation by the great speculator, George Soros.
As the price of the EURUSD gets lower, it’s likely to cause more clamor for the ECB to purchase sovereign debt. Since these purchases are viewed as causing a weaker EUR and more inflation, the act of ECB purchases cause the EURUSD to sink in value.
However, these purchases free up the ECB to purchase more debt. How does this work? As long as inflation remains contained, the ECB will continue to purchase more debt. This will put further pressure on the exchange rate channel, and reinforce the emerging view about Central Bank purchases – the view Central Bank purchases do not cause inflation.
The first thing to know about this is a lower EURUSD is the easiest way for Europe to solve their problems. Bruce Krastling pointed this out in a recent post – a weaker euro cures many of the problems for euro countries.
Germany Wants a Weaker Euro, Threatened a Meltdown to Get It
I’ve repeatedly stated Germany wants a weaker euro and the best way for them to keep the euro weak is to extend the crisis as long as possible. I think my first published article with this idea was in February of 2010.
However, part of extending the crisis means threatening to cause a massive banking crisis. Threatening financial Armageddon isn’t a precise policy tool, and also can require quick action to bring the world back from the brink.
The threat must be credible to make it work, and few people have the stomach to really plunge the world into another great depression.
Then, how do you control this threat? It’s not something you can ratchet up and down like the ECB lending rate. It’s an all or nothing tool – and something that can quickly get out of control with a single misstep.
Enter the Draghi: New Consensus “Solves” Problems, Weakens Euro
But the new consensus in the euro changes the dynamic in the euro. Instead of using threats of a crisis to push the euro lower, the Europeans can now use the short term solution to the crisis to push the euro lower.
While inflation hawks were running the ECB, there was little chance of the ECB purchasing significant amounts of debt over time – they simply wouldn’t stand for it. The risk of inflation was viewed as too high.
But with Mario Draghi taking the helm of the ECB recently, the ECB is viewed as being slightly more dovish on debt purchases. This opens up the potential for a situation that pushes the EURUSD considerably lower.
Germany can continue to stall on a long term solution, and even threaten a banking crisis. Then as threat to breakup becomes larger, the ECB can purchase debt, and push the euro lower.
A Central Bank buying debt has been viewed as extremely inflationary. I am calling it Quantitative Easing, but a smart commenter points out it’s actually Balance Sheet expansion. In either case, the practice was viewed as immediately causing inflation.
But the recent experience in the United States with QE showed something different. Despite gigantic QE – and even outright purchases of private market assets during QE I – inflation has been extremely subdued.
So the major argument against the ECB purchases doesn’t match very recent empirical evidence. It’s hard to claim ECB purchases of sovereign debt will cause inflation when U.S. Fed purchases of sovereign debt did not cause inflation.
Basically, as long as ECB purchases do not actually cause more inflation, Draghi can continue his high wire act.
In other words, the more the ECB does to solve the crisis, the more evidence we have the ECB temporary solution doesn’t cause much or any inflation. This action also pushes the EURUSD lower, which is something the eurozone wants.
The purchases can be extended to give the European Union time to come to a longer term solution.
Then, as the market realizes the New Consensus becomes something like an open ended QE program, the EURUSD will respond by moving downwards.
It’s not certain yet, but this does setup the potential for a large run to the downside in the euro. I pointed out earlier the gigantic channel and head and shoulders formation. I think the market mood wants to push the euro lower, and the political climate is very favorable for the euro to take a run at 1.1000 over the next few months.