It’s a common lament. The fundamental economic picture for the Eurozone single currency countries appears much worse, on a relative basis, than what we see in the United States, yet the euro currency doesn’t seem to reflect that reality. After much reflection on this topic, I think I finally figured it out—it’s a Pavlovian reflex response! Let me explain…
There was once a man named Pavlov. He had a dog. Being of the scientific bent, Pavlov decided to use his dog in an experiment. It was a conditioned reflex experiment. Pavlov hypothesized (which is what scientists do; investors guess as they cannot control their experiments) that if he rang a bell, then brought his dog a bowl of food, the dog would become conditioned to the bell ringing. Pavlov’s hypothesis proved correct for as soon as he rang the bell, the dog began to salivate in expectation of the food to follow. Thus it wasn’t the food itself that engendered the reflex, but the expectation of the food.
Insert European Central Bank, the European Union, and International Monetary Fund, collectively known as the “Troika” in place of Pavlov and “your average punter” in place of the dog and now you can understand why the euro is being supported—it is an expectation the future will be like the past.
The last time the power of ECB market intervention on a broad scale was put on display, bond yields fell and the euro rose sharply. The catalyst was the announcement of a Long Term Refinancing Operation (LTRO) announced back in October 2011. The LTRO was designed to provide the European banking system with a significant dose of liquidity. It succeeded, for a while, as you can see clearly in the chart below:
Below is the price action in the euro highlighted after the LTRO was announced on October 6th 2011; the euro rallied about 10 cents against the US dollar over the following two-week period:
So, will it be déjà vu all over again when Mr. Draghi announces bond-buying plans next week?
Bond buying, or put another way—the transfer of wealth from richer, more productive, taxpayers in the North to less productive more corrupt taxpayers in the South, will not change the core problem at the heart of the euro, which is this: the weaker countries cannot compete against Germany when they all use the same currency. If they try, it will mean decades of internal adjustment for the likes of Italy, Spain, Greece, and Portugal. It will mean lurching from one crisis to another, and muddling through at best.
For about seven years the periphery countries were able to borrow at interest rates on par with Germany. What good did that do other than allow consumers in the periphery to buy a whole lot of German made goods?
The Southern states, including Italy, Spain, and France, with the full support of the European Central Bank (ECB), now believe Germany needs the Eurozone to survive (because Germany’s growth model is one of export-dependence) and therefore will ultimately agree with the idea of making the ECB a tool for socializing risk—distributing more Northern wealth.
But, as the Eurozone recession deepens, I suspect Germany’s political and economic incentives to keep funding the single currency project will fade in direct proportion to the country’s falling trade surplus, falling industrial order book, and rising unemployment rate; all of which are now underway.
In short, the future may not be like the past. If the euro has already discounted what I’ve shared here, then there is a bell ringing, and it doesn’t mean food is on the way. It means the 600 pip rally we’ve seen in the euro from the July 24th low at 1.2041 is likely over and the long march down to par will continue in earnest.
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