Trump's Election May Strain The Euro To The Breaking Point

| About: CurrencyShares Euro (FXE)

Many would not have discounted the notion that financial markets would take kindly to the announcement that Donald J. Trump won the election. But when the news broke on 9 November that he will indeed be the 45th president of the United States of America, prices on international stock exchanges climbed, the US dollar exchange rate soared, and interest rates went up.

All this suggests that international financial markets' take on Trump's presidency is much more cheerful than the gloomy outlook many would have predicted. Mr. Trump has made no bones about his thoughts on US foreign and economic policy, but it remains to be seen if and how he will put these thoughts into action.

It seems Mr. Trump has no truck with the ranks of the globalists who, in their efforts to establish a new world order, have entangled the US in one ill-fated overseas adventure after another. Perhaps US foreign policy will change on his watch; it may well become far less aggressive. If Mr. Trump strikes a conciliatory tone in particular in his dealings with Russia, a more cooperative relationship could help deescalate conflicts in hot spots, say in the Middle and Far East.

In terms of economic policy, Mr. Trump's top priority appears to be boosting economic growth and creating jobs at home. How would his administration achieve this? Basically there are two options. First: The new president may focus on the supply side, cutting taxes for firms and income earners, while curbing government spending. Second: He may zero in on the demand side, encouraging more credit-financed spending on infrastructure and the like, while pursuing an overly easy monetary policy and taking up a protectionist stance on trade.

The first scenario would clearly be a regime changer. The US government machine, a juggernaut of swelling proportions, may not necessarily grind to a screeching halt, but its growth would be checked. This, of course, would be the boldest stateside political act in recent memory, and it would take some serious stamina to see it through.

But then Mr. Trump is a wealthy businessman with few allegiances to the party and little to fear from lobbyists. Perhaps he will capitalize on this independence and seize the opportunity to make a real difference. The situation is certainly auspicious enough with a Republican majority secured in Congress for the next two years.

The mere probability of the US economy improving under Trump's presidency has financial markets bracing themselves for higher interest rates. It is now widely expected that the Federal Reserve (Fed) will act on its plan to edge up borrowing costs further in December. If this comes to pass, the US dollar may appreciate further against other currencies, in particular the euro.

One reason is that the yield gap between the US and the euro is set to widen, making the euro less attractive vis-à-vis the greenback. On top of that, even if Mr. Trump's administration does not buy wholesale into the neo-isolationist ideology he espoused during the election campaign, it won't simply champion the cause of the globalists. As a result, the European integration project will be deprived of its most powerful intellectual and political advocate.

This should add to investor uncertainty as far as the euro's future is concerned. The United Kingdom's decision in June to do the "Brexit" has already dealt a heavy blow to people's confidence in the European Union (NYSEARCA:EU) being an economically and politically desirable institution. The chances of the project stalling are now even greater, and the ties that bind the union together may even unravel.

All this raises the question as to the single currency's raison d'être. Doubts about its viability will exacerbate the economic misery especially of weak euro member states. Investment in these countries will slow down, further suppressing production and employment. What is more, many euro zone banks engage in cross-border lending, and they will, of course, suffer if the euro's very existence is called into question.

Investors are already reluctant to extend new capital to ailing euro banks in view of their low profitability and sizable liabilities with so many bad loans on their books. More than ever, the weal and woe of euro banks is in the hands of the European Central Bank (ECB). However, the unhealthy liaison between the ECB and governments and banks in the euro area could now take a really bad turn.

On 26 July 2012, ECB president Mario Draghi pledged that "the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough." The ECB may now be forced to do exactly that: To buy ever greater amounts of debt against issuing ever greater amounts of money to prevent interest rates from rising and keep overstretched governments and ailing banks from defaulting on their obligations.

If it turns out to be a regime changer - by doing away with economic practices hitherto held dear by the current establishment, - Mr. Trump's presidency could actually test the single currency to the breaking point. A really plausible scenario is that sooner or later the ECB, desperately trying to prevent the euro debt pyramid from collapsing, pursues a policy of high inflation before the euro eventually falls apart.