The Euro 10-Year Anniversary - Muted Celebration

Ten-year anniversary coming up

The single currency - the euro - was introduced on 1 January 1999 and can thus soon celebrate its ten-year anniversary. Up to and after the launch of the euro, the project of the single European currency met with strong opposition. The Americans in particular regarded the single currency as definitely a political project unfounded on economic facts. The decision of the politicians to launch the euro at a higher exchange rate than the US dollar did nothing to mitigate the trenchant US critics.

The single currency was launched after the Asia and Russia crises. The euro was thus introduced at a period of high volatility in the financial markets and mercurial investor confidence. This meant that growth expectations for 1998- 1999 were lowered. In the event, the growth rate did not fall much during those years, and actually it was quite robust. But the rosy picture shattered after the turn of the century when economic growth came to its knees - when the US went into recession. Ever since, economic growth has been sluggish - although the years 2006-2007 promised better times to come. Now Europe is again about to buckle together with the US.

Sombre, dire or plain awful?

The economic clouds over the euro zone have become darker, and the big question is what kind of storm is brewing.

In our view, the European economy will remain very weak for the short term and may end up in technical recession over the second and third quarters, i.e., two consecutive quarters of negative growth, with things subsequently picking up. That is not to say that the sun will make all the black clouds evaporate, but that growth will slowly approach the potential growth rate by the end of 2009. We expect a growth rate of 1.3 % this year and 1.1% next year.

Not much cause for jubilation for sure - the scenario shows that the European economy is not very vigorous. In the current situation, the business tendency surveys - the PMIs in this instance - are illustrative and close to historically- low levels for several countries. If we add to this the risk of the financial turmoil continuing, the credit crisis deepening, and a halt to interest rate cuts on the part of the ECB for the time being, things honestly do not look very encouraging. In relation to our main scenario we also see the greatest risk on the downside.

It has been a difficult period for the euro-zone economy lately. Consumer spending in particular has been under pressure from the high inflation rate, while the housing markets have come under pressure in many localities. Moreover, unemployment is edging up in a number of countries, and for the euro zone overall the unemployment rate is rising. The rays of light on the consumption side are that wages are rising, and that prospects are for a fall in inflation, while the commodity prices of energy and food are no longer rising at a tearing pace.

Higher interest rates, softening house prices, poor prospects of growth and tighter conditions for bank loans cannot but put a damper on investment activities. Moreover, slower global economic growth, in the US and the UK in particular, makes it difficult to keep up exports. On the other hand, the expected appreciation of the dollar against the euro will be a godsend to European companies and to exports.

The ECB is sitting on its hands

There is not much help for the economy in monetary-policy measures. The ECB feels fettered by the fact that its main mandate is to ensure that inflation is stable at 2% - and with an inflation rate of currently 3.8%, it seems impossible for the ECB to facilitate economic growth. This holds even if the inflation rate was higher than expected extensively because if external circumstances such as sharp rises in food and energy prices. The ECB can only affect those circumstances marginally by pursuing a comparatively strict monetary policy.

Core inflation (excluding energy and food) is low and still below 2.0%. Unit wage costs, on the other hand, are edging up. They have been driven up by higher wage rises and a weak development in productivity. This is an important element which hampers the ECB considerably and is one of the main reasons why the bank will be very reluctant to lower interest rates. Therefore we do not expect the ECB to lower interest rates until the second quarter of 2009.

Several of the member countries have no room for manoeuvre in the way of fiscal policy: they risk violating the rules laid down in the growth and stability pact, according to which a country's budget deficit may not exceed 3% of GDP.

In France the fiscal policy cannot be eased. Italy is quite close to the 3% limit of GDP, and it will move closer still of the economic trends deteriorate. In Spain and Germany there seems to be better room for fiscal-policy manoeuvre. President Zapatero of Spain has presented a fiscal-policy package - with focus on assisting the construction sector. In Germany fiscalpolicy measures are only at the stage of discussion, and since the public budgets are now the best they have been for years, such measures are a possibility. However, Ms Angela Merkel has repeatedly said that the budget surplus must be ensured for the future, and that tax cuts cannot be introduced until 2010.

Euro - an ugly duckling

After a difficult start when the euro was forced to its knees against the dollar and for a short period traded around USc 0.82, the euro managed to initiate a lengthy uptrend supported by central bank purchases in the open market. This uptrend has lasted until now. And the euro managed to force the dollar to its knees by reaching a historically high level at 160.40. However, the vision of joining - perhaps even outflanking - the dollar as the world’s preferred reserve currency is far from accomplished. The American dollar is still the world’s predominant reserve currency in spite of the American IT and financial bubbles.

Beautiful swan on borrowed time

That despite all financial odds the euro turned into a beautiful swan is above all due to the fact that the euro as a financial experiment has never really been seriously tested by the financial actors. The recent economic boom has calmed the original fear of the member countries’ inherent economic differences so that the euro has long appeared as a credible alternative to the generally troubled dollar. Those times are now almost over.

The financial and economic crisis which is currently 1 year old has spread to the euro zone and has thus brutally revealed the large economic differences between notably the northern and southern euro zone. The economic distortion among the euro’s founders was one of the euro sceptics’ strongest arguments against the introduction of the single currency.

The economic differences have hindered the monetary-policy work for the ECB which is still left with the legacy of the Bundesbank - namely the inflation target. Notably the Southern European countries which frequently cut interest rates and devalued their currencies are not getting any help from the ECB - rather the contrary - despite markedly falling growth in these countries. As long as European inflation refuses to fall, it can be feared that the distortion will only grow and in the end seriously undermine the international investors’ confidence in the euro.

The financial markets scent blood

At the time of writing, the feathers are already falling off the swan after a steep fall from the top of about 10% against the dollar. Even though the ECB has not even considered following the same monetary-policy path as the Fed with resultant interest-rate cuts. That the financial market is currently scenting blood is not a claim but a fact.

A look at the 10-year yield spread internally in the euro zone reveals that countries such as Portugal, Ireland, Italy, Greece and Spain are already trading at fair premiums to German government bonds (see the chart below). Investors are thus demanding a premium to finance the rather large current-account deficits in these countries. The current yield spread corresponds to the high level (50 bp against usually 5-10 bp) which we saw in the spring when Bear Stearns was saved from bankruptcy by the Fed.

”The chain is only as strong as its weakest link”

Seen in a 10-year perspective, it can be concluded that the convergence process which has existed since the creation of the single currency is abandoned at least temporarily

The above may very well be an ominous sign of problems for the entire single currency project. If investors lose confidence in the euro - even if only temporarily - it will mean problems for the single currency.

Investors should never underestimate a financial market which scents the blood of the weak part. Not at all during the current turbulent conditions where the financial actors are on the defensive.

Due to the economic distortion in the euro zone, the current monetary-policy line and not least the continued high value of the euro, notably the tradeweighted value, the euro has long been at historically high levels (see the chart above).

We therefore see it as highly likely that in the coming months the euro will be tested like never before! Consequently, we expect an encounter with at least 125 during 2009.

Jyske Markets - FX Research
http://www.jyskebank.dk/finansnyt

The analysis is based on information which Jyske Bank finds reliable, but Jyske Bank does not assume any responsibility for the correctness of the material nor for transactions made on the basis of the information or the estimates of the analysis. The estimates and recommendation of the analysis may be changed without notice. The analysis is for personal use of Jyske Bank's customers and may not be copied.