Strategic Currency Briefing

USD/JPY84.01LONG USDWEAK11/15/1082.511.79%
GBP/USD1.5701LONG GBPWEAK12/14/101.5870-1.60%
EURO/USD1.3295LONG EUROWEAK12/14/101.3459-1.22%
EURO/JPY111.71LONG EURONEW WEAK12/15/10111.710.00%
EURO/GBP0.8466LONG EURONEW WEAK12/15/100.84660.00%
GBP/JPY131.91SHORT GBPWEAK11/24/10131.33-0.44
USD/CHF0.9620SHORT USDSTRONG12/14/100.96240.04%
USD/CAD1.0083SHORT USDWEAK12/13/101.00860.03%
AUD/USD0.9902LONG AUDWEAK12/14/100.9993-0.91%
AUD/JPY83.21LONG AUDSTRONG12/09/1082.550.80%
USD/MXN12.4044LONG USDWEAK11/30/1012.5035-0.80%


An aphorism from Nietzsche has been popular in recent years—“That which does not kill us makes us stronger.” (You can look this stuff up at The euro is demonstrating the aptness of the idea—each time the EMU survives another existential threat, the euro gets another coat of Teflon. We can joke that the first ECB chief Duisenberg started the Teflon-coating process and it just keeps going from there. If the euro can survive Duisenberg, it can survive Merkel. Now it looks like raising the ECB’s capital base will be the wormhole the EMU will wiggle through to avoid raising the EFSF or issuing e-bonds. As a stop-gap measure, we can’t find fault with it. After all, a central bank is a lender of last resort and it is the banks that are in danger of imploding. Banks are becoming the central bank’s constituency as well as its chief mechanism for meeting its single mandate of managing inflation.
Bloomberg poses the struggle as between German Chancellor Merkel and everyone else, including Eurogroup chief Juncker (who wants e-bonds) and Trichet (who disapproves of the ECB buying sovereign bonds to save banks in the absence of the banks raising their own capital but seems to be resigned to this role). Today Merkel is reported saying that “strict conditions” must be applied to countries seeking bailout funds. “For me it’s important that financial aid will, also in the future, be granted only as a last resort.” Remember that the summit starting tomorrow has as its purpose replacing the EFSF, set to expire in June 2013, with a permanent bailout facility. In other words, a permanent bailout facility is a done deal and now it’s only a question of what shape it will take. Trichet wants “maximum flexibility and maximum capacity, quantitatively and qualita- tively,” meaning more capital and more authority to spend it. It’s not completely clear, but it’s possible Trichet supports the view of the IMF, that it disburse funds pre-emptively.
The preemptive idea is not a bad one—we couldn’t do it in the US because of a strict adherence to market principles, but in the context of the control mentality in Europe, it’s a real possibility. This is Merkel’s escape hatch—she can win in opposition to the e-bond by allowing some agency, possibly the ECB, to intervene pre-emptively before a bigger EFSF is needed. Meanwhile, the need for an EFSF is not really in question anymore. It can be made permanent at the current level of funding with Merkel’s blessing as long as she gets her way on the e-bond. We don’t know the shape of the eventual compromise, of course, but armchair analysis makes it look pretty easy. If so, the euro escapes once again... and forecasts of the euro falling to 1.20 and 1.10 will be outdated before year-end. Note that there is still plenty of opportunity for euro-panic. The Treaty changes will probably go to the vote in March and members would have until the end of 2012 to ratify, according to Merkel’s speech today. We can expect some drama from one member or another refusing to ratify or otherwise kicking up a fuss.
As for the dollar itself, today we get CPI, among other things, probably a smallish rise by 0.1% in Nov (after a flat Oct). Of more importance is the lingering taste of the threat of a ratings agency downgrade arising from the expensive tax cuts that are not accompanied by other fiscal measures. The dollar gains support from an improving economy that lifts the 10-year yield but gives it all back on spikes of fear that the deficit is not being addressed. Rising yields are not always favorable—it depends on the reason. To the extent the bond vigilantes are holding the airwaves, rising yields are a problem, not a solution. It’s possible that what we are seeing in the 10-year is little more than those who had gone long getting their comeuppance for thinking the Fed was going to give them a gift, and resulting excessive selling. We are unable to get a clear and concise answer to why bond yields are so frisky, but it’s becoming worrisome that they don’t always provide dollar support. Historically, the link has been broken since the mid-1980’s, but we keep hoping that the positive explanation is the right one. In any case, the time is approaching when rising US yields may be seen as a thoroughly negative development. To avoid that outcome, we need a steady diet of ever-improving economic data. And how likely is that? (See sterling.) Therefore, we think the euro upside breakout is real and is getting both pushed and pulled.