Europe Still in Denial

As noted in the daily, Eurogroup head and Lux Prime Minister Jean-Claude Juncker has played down need to intervene in the foreign exchange market, saying there was no need to defend the euro.  Yet in the same interview, he claimed that the EU/IMF/ECB Stabilization Mechanism was necessary to defend the single currency.  Yet since the new initiative was announced, the euro has fallen over 5% against the US dollar and even more against the Japanese yen.  If the goal of the Stabilization Mechanism was to defend the euro, it does not look like it has been particularly effective.  Juncker suggests that the euro’s decline is "largely due to irrational approaches of the financial markets."  This is not a very helpful diagnosis of the problem.

Both Sun Tzu and Clausewitz would advise against under-estimating one’s adversary.  To assume the market is irrational is to under-estimate it.  It would be more productive to consider the factors the sellers of the euro are focused on.  They are not focused on solar activity.  Nor are they studying the entrails of a sacrificial animal.  They are focused on the macro economic fundamentals and the economic trajectory of the euro zone.  Many investors continue to believe that some kind of debt restructuring is necessary and there are many who perceive in the current crisis, existential issues for EMU.  Juncker says that market participants are "insufficiently" taking into account Europe’s response to Greece’s debt crisis.  To the contrary, the many investors have seen the response as yet another reason to sell the single currency.  First, even if sterilized, ECB purchases of sovereign bonds is a type of quantitative easing or as the US called its version, credit easing.  Second, if one of the underlying problems is excessive debt, it is not clear how guaranteeing the debt or the ECB purchases addresses this issue.  Third, new fiscal austerity measures seem to increase the likelihood of stagnation for the region, which over the last five years has grown on average of 0.75% and in the five years before that annual growth averaged 1.25%.  The risk is that the output gap created in the recent economic contraction widens further before closing and this has ramifications for European interest rates, earnings and profitability.

Ironically, Juncker says that two weeks ago Europe had to take action to defend the euro, but although it has fallen further, no defense is needed. He fails to square the circle and this only adds to the pessimism surrounding the euro’s outlook. One is left with the impression that currency moves that officials like Junker agree with or desire are rational, and those currency moves that are less desirable are irrational.  Even though the euro is two cents off the multi-month low set earlier this week, the premium participants are paying for euro puts over euro calls is still near record extremes (more than 3%) and 3-month implied volatility is near the recent high of 16% (a couple percentage points above where it was during the 9/11 period).  Other disruptions in the capital markets continue, with not just equity markets tumbling, but also pressure becoming more evident in the money markets, such as LIBOR and index swap spreads.  International pressure is likely to mount for Europe to staunch the hemorrhaging.

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