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The Euro and British Pound Come Down to Earth

Mon, Oct 6 2008, 13:43 GMT
by Jack Crooks

Money and Markets

Don't look now, but the Eurozone and England are in big trouble.

Actually, you do need to look now because there's no point in turning your head away from what's driving global financial markets and more importantly ... currencies.

It's almost as if U.S. Treasury Secretary Hank Paulson bailed out Europe and the United Kingdom. How? Whether or not his plan works to restore confidence in the U.S. financial system, this controversial $700-billion proposal he's been trying to push through Congress is sucking up so much attention from the markets that developments on the other side of the Atlantic are going relatively unnoticed.

Currency investors, however, aren't shrugging off the revelations. That's why both the euro and the British pound bowed at the feet of the dollar again this week.

For the euro, the correction didn't last long. It plummeted through a key low established within the last month.

The above chart doesn't bode well for the euro by any means. My next target is a key level of support just north of 13300.

As for the pound, it did behave much better. On a daily basis, it still sits above the key low established a few weeks ago.

But by the looks of this chart, a weekly view, the pound should still be in for some major steps lower. I'm eyeing 17150 as the first target, and then 15750 after that. The way things are shaping up (or perhaps I should say shaping "down") it's not a far stretch by any means.

Fundamentals Across the Atlantic Point Straight Down

Within the last week or so the market got a good glimpse of the situation in the European credit markets. And let me tell you, it's far more sobering than most expected.

The most noticeable problem is that banks are leveraged up on loans to an extent that easily exceeds the leverage of at-risk banks in the United States. In layman's terms, the amount in loans makes up too great a portion of the amount of deposits coming into banks.

And there's where the biggest worry lies. It's sparking all kinds of action among European central banks and governments:

• * More than 11 billion euros were pumped into Fortis SA this week thanks to Belgium, the Netherlands and Luxembourg.
• * Belgium also teamed up with France in providing more than 6 billion euros to Dexia SA.
• * Germany helped out Hypo Real Estate with a loan guarantee.
• * Ireland also stirred the pot in saying it would guarantee 400 billion euros of deposits and debts belonging to its domestic banks for a period of two years.

Throw into the mix Iceland's little bailout of Glitner Bank and you can see the type of havoc this stuff can wreak on a currency.

Government bonds, in reaction to the 600 billion euros thrown into a 75% stake of Glitner, are now rated below investment grade. The Icelandic krona ... well ... let me just say it's seen better days. The last time the value of the krona was as low as it is today ... 2001.

The Iceland krona (and other emerging/developing European nation currencies) has been crushed relative to the U.S. dollar because of the credit crunch in Europe, as you can see in the chart below:

Iceland krona — US$ Weekly

The rate which European banks charge one another on three-month loans (Euribor) jumped to its highest level ever this week. Libor, the three-month rate at which foreign banks can borrow U.S. dollars, surged again and remains at the highest levels since January.

The European Central Bank is pumping money, too. The latest auction of $50 billion worth of three-day loans comes on the heels of billions of dollars auctioned off earlier in the week. That's not to mention the additional money shoved through auctions in the weeks prior.

The worst part of all this is that it pretty much isn't working to lubricate the gears of the lending system. Apparently banks are funneling cash back into the ECB's deposit facilities. So far more than 100 billion euros have supposedly been dumped back into the ECB because banks are fearful of stashing it anywhere else ...

Boy, oh boy, it's ugly out there.

The Battle of Britain

Just so they're not left sitting at home while the bailout party rages on, the U.K. government seized the country's biggest lender to landlords, Bradford & Bingley Plc. They also lent a hand in rescuing HBOS Plc. The Bank of England then auctioned $30 billion worth of one-week funds and $10 billion worth of overnight loans. Earlier in the week they pumped emergency funds into money markets.

And if that wasn't enough (as seems to be the case with all lending assistance these days), the Bank of England widen the collateral they would except for three-month loans to banks. If you have some decent securities tied to corporate bonds, or perhaps some top-notch Asset-Back Commercial Paper, then you are in luck — you can dump that stuff on the BOE and come away with a loan.

It's easy to see credit markets are not functioning. And the U.K. economy is paying for it.

For the month of September, a gauge of U.K. manufacturing fell at its fastest pace since record-keeping of such data began in 1992. A stagnating services sector in the three months ending in July added to the pain. House prices fell 3.9% in the second quarter, in case the housing situation wasn't already bad enough.

What this hideously awful combination of economic fundamentals and a dysfunctional lending system creates is a renewed call for interest rate cuts for the European Central Bank and the Bank of England.

Narrowing Yield Differentials on Our Minds

Analysts across the board jumped at the chance this week to proclaim their monetary policy predictions. These beacons of light expect both the European Central Bank and the Bank of England will cut interest rates before year-end.

The ECB concluded a meeting just this week where they stood pat on rates — though Jean-Calude Trichet, ECB President, did discuss the potential for reducing borrowing costs. This is a big deal for the financial media since Trichet has been sticking to his guns in fighting and preventing further inflation.

The Bank of England, on the other hand, meets this coming week and many see a rate cut at the meeting as inevitable. I'm not so sure because often reality throws analysts' predictions right back in their faces. I will say, though, that the Bank of England has surprised me thus far. They've not budged in the face of economic deterioration. But I don't think they can hold the line much longer.

The risks for either of these central banks are huge. And what that will do is surely undermine their respective currencies. But regardless of the outcomes at the monetary policy meetings that wrap up the year, the currency markets understand the conditions across Europe and are already reacting ... and fast.

Published on  Mon, Oct 6 2008, 13:43 GMT

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