by Don Alexander, MBA
Associate, RSD Solutions Inc.
As we enter 2012, the euro has emerged as the weakest currency against the US dollar among the major currencies. Investors still continue to short the euro on expectations the currency move lower is not finished. This view is based on the ECB facility is a stop-gap measure and does not resolve the solvency issues. Investors note the following: the Greece refinancing led by the IMF is still not functioning as expected, the cost of Italian and Spanish debt still remains around 7%, European banks are having a difficult time raising new capital and real investors lack additional appetite for further euro risk exposure.
Global economic indicators have started to improve, especially in the US. However, the demand for European risk assets remains weak as the focus remains on a potential recession and contagion impact to the global economy. Previously in 2011, anytime the euro came under pressure it was often followed by a countertrend rally. However, 2012 could be different as real non-European investors continue reducing their euro sovereign bond exposures. The supply surge of sovereign debt, euro $1 - 1.2 trillion, coming to the market in 2012 and the rollover, euro 700-800 billion, of bank paper/new capital could cause digestion problems as global investors to reduce European exposure.
In 2011, the US dollar was used as the funding currency for risky assets. Given the prospect of a European recession, will cause the ECB to further cut rates and keep them low for an extended period. The poor reception of capital market issues of European banks suggests that further balance sheet contraction is needed to meet the higher capital ratios. Banks continue to place funds with the ECB and not employing the central bank liquidity in the real economy. Real yields have moved into negative territory as the ECB tries to promote an investor shift into riskier assets. The problem is that the time lag between liquidity creation and a move into risky assets has a time lag. However, the uncertain outlook suggests this delay may take an extended period of time.
The use of the euro as a funding currency rather than an asset currency, a prolonged period of low ECB rates, the prospect of a European recession and uncertainty from the overhang of sovereign/bank debt will push the euro lower. There will be limited countercyclical euro rallies compared to 2011. The euro downtrend should continue through the summer until either political gridlock in Washington grabs investor attention as the November election approaches and/or policymakers can provide a resolution for the sovereign debt/banking crisis in Europe.
