The Eurozone Drama Continues
Confluence Investment Management
By Bill O'Grady
August 14, 2012
In late June, Eurozone leaders appeared to have made a breakthrough. Italian Prime Minister Monti challenged German Chancellor Merkel, indicating that he would not sign on to anything until Germany backed off its demand that any ECB or EU assistance had to come with conditions attached. It appeared that Merkel had buckled; markets rejoiced. However, as Spain’s banking system requested a bailout, conditions were attached. It appeared, in the end, that the Germans had won after all.
Soon after the Spanish bailout, sovereign yields in the Eurozone periphery soared. Spanish 10-year yields not only rose above 7% (the area that has tended to signal a crisis), but its 2-year yields did as well. The rapid rise of short-dated yields indicated that Spain was in serious trouble.
Risk assets (equities, commodities, corporate bonds, foreign currencies) began to weaken and safety assets (Treasuries, the dollar) began to rally. These trends were reversed in late July due to rather aggressive comments from ECB President Draghi, who strongly indicated that his central bank was preparing measures to bring down sovereign yields. Consequently, risk assets soared and safety assets declined. On August 2nd, the ECB held its regular policy meeting—markets waited with anticipation for Draghi to reveal what exactly the ECB was prepared to do.
Instead of getting a roadmap of what measures the bank would implement, investors received vague promises of new measures. Risk markets were promptly sold lower and safety assets rose.
However, the next day, risk assets recovered and have continued to rally while safety assets have weakened. There have been numerous comments about why this reversal occurred. Such commentary isn’t unusual; the financial media tends to find “answers” for market events. On balance, it appears that the media coverage missed the seminal reason for the recovery.
In this report, we will review the political and economic structure of the Eurozone. From there, we will discuss the critical event that caused the reversal in safety assets and what this reversal likely means for the geopolitics of the Eurozone. As always, we will conclude with potential market ramifications.
The Eurozone
The Eurozone is the latest response to the geopolitical issues of Europe and Germany’s specific role within the continent. The problem with Europe is its geography. The Baltic Sea has prevented the continental powers from easily invading Scandinavia. Mountain ranges isolate Italy and the Iberian Peninsula. The British Isles are isolated enough to allow the British to act independently of the continent and yet be in a position to blockade any continental power.
The nations of Europe were able to become the most powerful on earth from the early 1800s into 1945, but none were able to dominate Europe. This did not stop the Europeans from fighting each other to establish dominance.
The establishment of Germany in 1871 created a nation centered on the continent with few natural defenses and the potential to be an economic powerhouse. As Germany rapidly industrialized, it soon became a major competitor to Britain and France. At the same time, Germany faced hostile powers on both its eastern and western borders. German military leaders felt they could defeat either France or Russia but could not prevail against both simultaneously. German war plans generally sketched a rapid victory over France followed by turning against Russia. That plan failed in WWI but worked in WWII, at least initially.
After WWII, the EU was formed to prevent another major war from being fought in Europe. This meant that the nationalism that led to the previous wars needed to be suppressed. The political elites in Europe realized that the feelings of nationalism were too strong to overcome; instead of immediately moving to create political unity, officials instead opted for economic unity. They hoped that through economic integration the forces of nationalism would steadily erode and become less of a problem over time.
The first task at hand was to deal with the aforementioned German problem. After WWII, the German situation was addressed by partitioning the country and wedding West Germany to Western Europe via the EU. France embraced its former rival and used the dynamic German economy to project power on the world stage. Before unification, Germany was content to allow the U.S. and France to determine its foreign policy and pay for most of the EU economic project. However, after unification, Germany began to stake out its own path.
After unification, in order to keep Germany wedded to the EU, France insisted that the EU adopt a single currency. The French hoped the single currency would allow them to maintain some degree of control over Germany. As the Eurozone has evolved, instead of containing German power, it has facilitated its expansion.
Germany has been a traditional exporting power. Like many of the successful post-WWII economies, it developed by export promotion. As long as the U.S. was willing to be the global importer of last resort, export promotion has proven to be the most successful path of development. However, exports within Europe prior to the creation of the euro tended to be stunted by the persistent depreciation of European currencies. Although European currencies were somewhat pegged via the European Monetary System, which was designed to limit the movement between the exchange rates of Europe, in practice, the D-mark steadily appreciated against these legacy currencies.
This chart shows the four major southern periphery currencies along with the D-mark. We have rebased these currencies to 1970; since they are all quoted in the amount of foreign currency per U.S. dollar, the higher the number the weaker the currency’s exchange rate. We have also inverted the scale to show the direction of the market. Clearly, Portugal and Greece were poor candidates for inclusion in the Eurozone. In the 30 years prior to the onset of the euro, the escudo had depreciated by 800% and the drachma by more than 1300%. Even Spain and Italy used weakening currencies to maintain competitiveness with Germany.
The vertical line shows the onset of the euro. Note that these currencies effectively appreciated since the onset of the single currency, undermining the competitiveness of their economies.
By establishing the Eurozone, Germany was able to create a large internal market for its exports. The German trade surplus clearly shows how important the euro has been for German trade.
This chart shows the German trade data. Note that Germany ran a trade surplus in most years from 1960 but that surplus has increased significantly with the creation of the Eurozone, depicted with a vertical line. German exports have increased dramatically as well. In comparison, U.S. exports represent around 10% of U.S. GDP.
It should also be noted that entering the Eurozone set off a massive decline in interest rates among the southern tier nations.
These charts tend to undermine Germany’s domestic political narrative regarding the Eurozone crisis. Chancellor Merkel has argued that it was fiscal indiscipline that has caused the crisis. Entering the Eurozone led to a drop in interest rates as investors believed that all sovereign debt in the group was essentially the same credit risk. As the rate chart above indicates, that seemed to be the case until 2008. However, since then, yields have diverged. The German cure is austerity, designed to reduce debt and interest rates.
There is another narrative that competes with the German story. Essentially, the argument is that Germany structured the Eurozone to expand its export markets. Along with the financial market’s misperception of credit risk, these factors touched off a consumption boom in the south that further facilitated German export expansion. In this account, Germany took advantage of the southern periphery, using their growth to boost exports. The inability of these nations to depreciate their currency undermined their competitiveness, which had been the pattern prior to the adoption of the euro. Interestingly enough, German banks were recycling their trade surpluses either by loaning to periphery countries or by purchasing their sovereign debt.
Which account is accurate? To some extent, both are. The key is the emphasis. Germany, having the role of creditor, wants to get paid back in valuable euros and wants to enforce its claims by creating political structures to ensure payment. This is why Germany acted to prevent a referendum in Greece and strongly supported the appointment of Mario Monti as prime minister in Italy. It is also why Chancellor Merkel is pressing so hard for EU oversight of banking and fiscal matters. The Germans want the rest of the Eurozone to sacrifice sovereignty to ensure that Germany can control the flow of funds that comes from bailouts. Germany knows that austerity is unpopular and wants to ensure that political sentiment doesn’t lead a country to repudiate its debts or leave the Eurozone.
The periphery nations instead want to frame the argument to indicate that entering the Eurozone was a ticket to a rigged game. In other words, Germany structured the Eurozone to its benefit and thus has an obligation to support these economies.
The Role of Finland
The northern Eurozone has tended to back the German narrative. Thus, on August 3rd, when risk markets rallied, the key factor appeared to be comments from Erkki Liikanen, a Bank of Finland governor and a member of the ECB. Risk markets were weaker on August 2nd, after Draghi failed to offer concrete action to respond to the Eurozone crisis and it appeared that another negative trading day was in store. However, markets turned sharply higher after Liikanen reiterated Draghi’s comments from the previous day.
So why are Liikanen’s comments so powerful and Draghi’s a disappointment? It’s all about location. Finland has been one of the most hardline northern countries when it comes to dealing with the periphery. It has persistently demanded collateral for bailout programs and has been an opponent of nearly all the support measures. If the Finnish central bank representative is giving his imprimatur to Draghi’s program (whatever that actually turns out to be), it means that a major opponent to Eurozone adjustment has acquiesced. In addition, it suggests Germany is becoming increasingly isolated. If Finland will support ECB balance sheet expansion and bond buying, Germany will be hard pressed to prevent it from occurring.
Germany’s Precarious Position
Germany’s export growth supports the notion that it has benefited greatly from the Eurozone’s creation. It would follow that it isn’t in Germany’s interest for any nation to leave the Eurozone; otherwise, the exiting nation could re-issue legacy currencies that would surely depreciate against the euro and improve that country’s competitiveness. At the same time, Germany does not want to have an open checkbook to persistently bailout these countries because, in fact, the Eurozone periphery should implement labor market reforms. Without these reforms, these nations will never be able to compete.
Chancellor Merkel has generally hewed a hard line with Eurozone nations in trouble, insisting on memorandums of understanding and conditionality for support. For domestic political reasons, she wants to show that these bad debtors are being whipped into shape. At the same time, Germany does not want anyone to leave the Eurozone. Going back to the pre-Eurozone period means that Germany will have a very strong exchange rate that will undermine its export sector.
The Greek Syriza Party has generally figured this out. Their position was to either get aid or default on their debts and dare the rest of the Eurozone to expel Greece. The party’s leadership believes (probably correctly) that the Germans wouldn’t dare kick them out because it is possible Greece would be better off without the euro. If this turns out to be true for Greece, it’s likely the same for other troubled debtors.
Merkel’s policy has been to push a hard line but eventually relent. However, that policy is becoming increasingly untenable. Germany needs the periphery nation consumers. Export promoters usually fund the economies of their importers because growth in the exporting nation falters without the recycling of surpluses. Merkel’s behavior is a bargaining position; she wants to get the best deal possible without being so harsh that nations default and leave the Eurozone.
It appears that ECB President Draghi has decided to call Germany’s bluff. Of course, Draghi is a conventional central banker. ECB policy has not been as aggressive as the Federal Reserve’s but his recent comments suggest he is heading in that direction. Germany is becoming increasingly isolated in the Eurozone and, over time, will be forced to acquiesce to inflationary policies designed to overstimulate Germany and support the Eurozone’s southern tier.
Ramifications
The market ramifications of this situation are fairly complicated because the Federal Reserve appears to be leaning toward additional stimulus as well. It is growing increasingly likely that the two major reserve currency central banks may soon implement additional unconventional monetary policy programs.
If implemented, it is worth noting that both nations would be using currency debasing policies. Other countries would either have to deal with appreciating currencies or engage in similar policies themselves. Interestingly enough, market behavior since the 2008 financial crisis shows that the euro tends to gain on the dollar unless it appears the single currency is in danger of breaking up. If this pattern holds, the euro would gain on the U.S. dollar. However, this pattern may not hold, especially if the U.S. economy continues to outperform Europe. For the Eurozone, a weaker dollar would tend to undermine the stimulative effect of quantitative easing.
Commodity prices would tend to benefit as well, especially if China begins to stimulate too. There are signs China is ramping up investment which usually increases commodity consumption. Equities would likely rally as well.
Unfortunately, the direction of markets will remain focused on policymakers, who are under tremendous stress to address historic problems. The chances of getting policy wrong, or misreading another leader’s signals, are high. However, it does appear that both ECB President Draghi and Federal Reserve Chairman Bernanke are leaning toward the expansion of balance sheets to lift growth. They both face potential obstacles in that process. Ultimately, we believe the ECB will probably be able to overrule the Germans in order to boost European stimulus.
Bill O’Grady
August 13, 2012
This report was prepared by Bill O’Grady of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.
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