The euro remains immune to a negative bias

Outlook

Market News makes the remarkable statement: “In currencies, FX traders mostly remained dollar bulls and were watching for any larger dollar dips so that they can re-enter a long position against select major and EM currencies. The euro is another animal, they said, and playing the range there may make more sense.”

In other words, the tide has already turned in the dollar’s favor, thanks to the tapering/rising yields story, but somehow the euro remains immune to a negative bias. This is what we have seen throughout the euro’s history and it’s an enduring puzzle. We have proposed that the euro retains power because the Maastricht Treaty and Stability Pact embody a new gold standard—controlling inflation above all else. But still, it can be hard to swallow sometimes, and this is one of them.

We are more worried right now about a crisis or shock. We haven’t had one in a while and we are about due. Okay, that’s to accept the gambler’s fallacy (that after a string of heads, a tails must be coming). But realistically, the world is ominously peaceful right now. Trying to forecast a surprise is obviously a fool’s game, but let’s do it anyway. We see trouble looming on several fronts that can throw up a punch in the face.

First is this business of closing US embassies in the Middle East. Ahead of the 12th anniversary of 9/11, it’s no doubt wise to tighten security, but surely an attack has to be on US (or European) soil, and has to affect a lot of people. Closing embassies that are already fortresses in many cases seems a funny way to respond to “chatter.” Bottom line—what does the intelligence community know that they are not telling us? Or do they know anything at all?

Second is the Japanese nuclear accident from March 2011 that is still with us. The Fukushima plant is leaking radioactive water into the sea. This is not being taken as the horrendous scandal that it really is. It’s a terrible loss of face for Japan and may even imply severe diplomatic pressure against Japan should Mr. Abe try to amend the constitution to allow war powers.

A third factor is that Congress has gone home for five weeks without having fixed the sequester or any other budget issue, let alone the continuing resolution that allows the issuance of debt to fund the government. It happens that the government has to issue less debt because the recovery has raised tax revenue, but debt remains and still has to be rolled over. This leaves us with the prospect of another government shut-down in late September. Nobody is worrying about this at all. What’s the matter with us that we elect these idiots?

A fourth factor would be another peripheral European debt crisis. Today Bloomberg reports that Portugal is borrowing from the ECB at the highest levels in 7 months, €50.2 billion in June (it peaked last June at € 60.5 billion). We are keeping an eye on yields in the hope that the enxt crisis, if there is one, will be seen there first.

A fifth possibility comes from an economist who rejoices in the name George Magnus, advisor to UBS, writing in the FT. He points out that China’s fate is far more important to the global economy than the Fed tapering. He has a somewhat different view of the historic shift to a rebalanced economy. Lots of analysts have written about the issue but this guy has the Big Picture. “One way or another, the model is going to change. The role of physical capital formation will fade as the economy rebalances. Physical labour input has been more or less exploited, and the credit intensity of GDP growth has to be brought down. China’s top leaders understand this, but changing the model to one based on efficiency, innovation and a greater role for markets at the expense of the state, is easier said than politically done.

“Even if they succeeded, making the change could only be done in the context of slower, sustainable growth, and policies designed to absorb or address overcapacity in heavy and commodity-intensive industries, and a rise in debt service problems, defaults, and non-performing loans. This comprises an unequivocally deflationary risk for global markets, which is likely to challenge risk appetite again and push up the US dollar, especially against emerging market currencies, including even the renminbi.

“In China, the GDP deflator (a measure of the level of prices of all new, domestically produced, goods and services in an economy) has already slumped to a reported annual rate of 0.5 per cent in the June quarter, from around 7 per cent just two years ago. The combination of overcapacity in several industries and weaker growth could generate further downward pressure on Chinese goods prices at home and abroad.

“Industrial and mining commodity exporters face a daunting time as the share of property investment in GDP falls from a lofty 15 per cent. The income and wealth effects on sectors from steel and cement to white and luxury goods could affect up to 35-40 per cent of the economy. Against this backdrop, concerns about tapering are little more than the proverbial rounding error.”

Rebalancing the Chinese economy is not a one-time shock like a terrorist attack, but something like a Shanghai Surprise arising from rebalancing would be a one-time shock. We could also see re-allocation of reserves, where the announcement effect is sure to be huge even if the sum is small. Or China could choose to distract the attention of the public by picking a fight with Japan. However it manifests itself, a Chinese Event seems likely.

It’s a slow week and there are lots of ideas floating lazily around in the breeze. We agree with Market News—the dollar “should” be higher with that one exception, the euro. But if the euro is the benchmark, what does that mean? Besides, the pound and AUD are moving for their own reasons. Bottom line, today might be a good day to be tentatively long USD but with a solid stop.