While the euro currency appears to have been saved for the time being, Europe still faces years of austerity, mountains of debt and little or no economic growth, CME Group Chief Economist Blu Putnam wrote.
Market nsightsBy Blu Putnam, Chief Economist, CME Group october 24, 2012Euro Saved for Now; Europe Still inRecession and Debt DenialThe post-financial crisis years have not been kind to expansion for years to come. Put another way, the U.S.Europe. The eurozone has suffered through a seemingly dollar, British pound, Japanese yen, and euro arenever-ending sovereign debt and bank capital adequacy all sick currencies to some degree. The challengecrisis, which began in Greece but quickly spread. The for currency market practitioners is to deciphereuro rebounded only when the European Central Bank which ones merely have the flu and which ones are(ECB) in September made open-ended commitments in intensive care. That means projecting which of theseto maintain the single currency and buy short-term currencies is likely to be stronger boils down to assessingsovereign debt as required (albeit with some potential their relative weaknesses. It is not a pretty picture.conditionality). As we monitor developments in Europe, Fundamental and quantitative models of currencywe are struck by a number of incongruities that threaten movements typically rely on two relationships: relativeto plague the economy, even if the currency has interest rates, and trend or momentum patterns intemporarily stabilized. exchange rates. Neither factor provides much guidance in the current environment. As already noted, forEuro Saved for Now currency markets, there is no signal whatsoeverThe ECB was established specifically to manage the from relative interest rates, since the central bankssingle currency. Had it failed to provide the commitments of the four major currencies are all mired in extendednecessary to secure the future of the euro, it would stretches of extremely low rates. And while currencyhave destabilized Europe, opening itself to charges of markets historically have been the poster child for thedereliction of duty and, certainly, abandonment of its maxim – “the trend is my friend” – the trends lately haveraison d’etre. Nevertheless, the medicine is likely to proven unreliable. This reflects the reality that amongcome at a steep price. The ECB’s long-term and open- the major currencies political decisions, rather thanended commitment portends a lengthy period of very economic drivers, have taken the lead in determininglow short-term rates and balance sheet expansion. The short-term exchange rate movements.euro probably would be yet weaker than it is today if theU.S. Federal Reserve, the Bank of England, and Bank of Political decisions have their own dynamics, decidedlyJapan had not made largely similar commitments to different in nature from the evolution of economies. Inmaintain near-zero short-term rates and balance sheet an atmosphere of crisis, pivotal political decisions areThe research views expressed herein are those of the author and do not necessarily represent theviews of CME Group or its affiliates. All examples in this presentation are hypothetical interpretations ofsituations and are used for explanation purposes only. This report and the information herein should notbe considered investment advice or the results of actual market experience.
october 24, 2012typically born of brinkmanship. Because it is inherently depends on tackling pension costs. Greece, with its backbinary, the political decision-making process itself may to the wall, has cut government pensions by 10%. Butemerge as a source of market disruption. It confronts France has moved to lower the retirement age, and Spainmarket participants with sorting through the complex has declared cutting pensions politically unacceptable.expectations embedded in a probability distribution This is the wrong direction for obtaining fiscal balance.with two modes: typically, a low-probability scenario But cutting government pensions would spell politicalin which policymakers flirt with severe financial doom for any politician who embraces reality. Denial isdisruption by failing to take appropriate policy actions, currently the preferred course.and a high-probability scenario in which everyone Second, banking systems must be recapitalized. It ismuddles through the crisis by virtue of last-minute ad not just fiscal austerity that is holding back growth inhoc policy actions. Moreover, the uncertainty created many European countries. When banking systems doby political brinksmanship fosters an overall loss of not function well, economies do not grow. Of course,market confidence and a persistent sense of gloom. there is a justifiable and appropriate movement forIn short, with each major country temporizing over its tougher bank regulation. But if Spain and other Europeanown political quandaries, the binary nature of political nations want growth to resume, they need to get theirdecision-making in crisis overwhelms any discernibly banks recapitalized sooner rather than later. Progresspersistent trend in currency markets. (The interested on this front shapes up to be torturously slow, sincereader may wish to see the academic analysis in the implication is that someone has to take some big“Thoughts on Volatility, Correlations, Expectations losses in the process. Our perspective is that a poorly-Formation, and Risk Management in the Era of functioning banking system deserves more or lessDissonance, Review of Futures Markets, 2012.”) equal responsibility with fiscal austerity for the current recessionary environment in many European countries.Austerity and Denial Taken together, our assessment is that Europe willThough the ECB has come to the rescue of the single remain in debt denial (restructurings are probablycurrency, at least for now, the economies of Europe face necessary), austerity will be in place for many more yearsausterity for a long time to come. The demographic and the banking system has years more to go beforereality of Europe is that the population is aging, having the capital and profitability to function properly.not growing. Without strong labor force growth to This makes it difficult to become more optimistic aboutpower dynamic economic activity, there is little the European economic outlook, even if we are, for now,to no hope that Europe can grow its way out of its no longer worried about the break-up of the euro.massive overhang of government debt. This hasnot stopped the European Union (EU) from trying todevise bailout plans that assume that all EU debt issuedin a rescue plan will be repaid in full. The assumptionthat debt restructurings and write-downs can beavoided is tenuous. Two things would have to occur forthe European governments in deepest debt to avoidrestructuring; neither is likely in the short run.First, European countries must devise a way to cuttheir government pension obligations. Meaningfulfiscal spending reform, from Spain to France and beyond,2 market insights