THE UGLY-BUG BALL / THE ECONOMIST ( VERY HIGHLY RECOMMENDED READING )

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The ugly-bug ball

Traders are picking on the euro again

Jan 14th 2012
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ALTHOUGH 2011 was filled with headlines about the potential demise of the single currency, the euro did not actually fare that badly in the foreign-exchange markets. Its trade-weighted decline for the year was only 3.3%.



But traders went into 2012 betting on a further fall. Figures from the Commodity Futures Trading Commission showed a record short position in early January. Sure enough, the euro slipped below $1.27 in the year’s first trading days, before recovering slightly.


Before predicting a collapse in the euro’s value, however, it is worth remembering a couple of salient facts. Markets often make sharp moves in the first days of January that are not sustained in the rest of the year. The euro fell by 3.6% against the dollar in early 2011 before stabilising. The presence of so many bearish bets is a classic contrarian signal that all the bad news may be in the price.


Secondly, foreign-exchange markets are an “ugly contest” in which traders and investors have to pick the least-worst currency. Most developed countries would like to see their currencies fall in order to help their exporters.


Switzerland is trying to cap the level of the franc. Japan has repeatedly intervened to prevent the yen from strengthening too far. America has seen its debt downgraded by Standard & Poor’s and runs its fiscal policy via a series of 11th-hour compromises.



So what explains the current bias against the euro? There is some evidence that central banks are losing enthusiasm for diversifying their reserves into euros. Between the third quarter of 2009 and the same period last year, the euro’s share of central-bank reserves fell from 27.9% to 25.7% and the dollar’s proportion nudged up slightly from 61.5% to 61.7%. It seems as if central banks have been spreading their net more widely into the likes of the Australian and Canadian dollars.



There have also been signs that the American economy is doing rather better than its European counterpart. Whereas the euro zone may already be in recession, America could enjoy a year of “trend” growth. The labour market is improving, as are other signs of confidence such as house purchases and car sales.


In addition the link between the dollar and the “risk on/risk off” trade may be weakening. Ever since the financial crisis, the dollar has tended to do best when investors are cautious (the risk-off phases) and to fall when they are feeling optimistic. Perhaps American fund managers were selling dollars to buy foreign assets when in upbeat mode and bringing their money back home at more downbeat moments. But their appetite for foreign equities may be waning, especially since Wall Street outperformed European stockmarkets in 2011. So far in 2012 both equities and the dollar have risen.


For much of 2011 the euro also had a clear yield attraction over its main rivals (the dollar, yen and sterling). But two rate cuts in the autumn have brought euro-zone rates down to 1% and further cuts are expected later this year.
There is talk that the euro is now being used for carry trades, whereby investors borrow in a low-yielding currency (like the euro) and invest the proceeds in a higher-yielding asset, such as the Australian dollar.



Some believe that the European Central Bank will eventually be forced to adopt quantitative easing (QE) as the only way of helping the region out of its debt crisis (the recent provision of three-year liquidity to the banks is a step along that road). It is hard to be sure whether such a move would be bullish or bearish for the currency. The conventional assumption is that creating more currency is bad for its value: QE in America is generally agreed to have been negative for the dollar. But if QE is perceived to stabilise the European economy, it could end up being positive for the euro, at least in the short term.



As far as European economies are concerned a moderate decline in the euro would probably be good news, as it would deliver a modest stimulus at a time of turmoil. Few want to see the euro regain the heights of $1.60 reached in 2008.



The big risk, of course, is of a break-up of the euro zone, with Greece being the obvious candidate to depart first. The potential for contagion in the other peripheral economies means that such a move would almost certainly precipitate a wider banking crisis. Although the euro might still survive in the core countries like Germany and the Netherlands, Mansoor Mohi-uddin at UBS is surely right when he says that “the prospect of a stronger euro shorn of its weakest links would take years to materialise.” A break-up would turn a decline into a rout.