Currencies | Dec 13 2011
– Eurozone debt crisis not a currency crisis
– CBA suggests sharper correction in euro not expected
– Any further downside in EUR/USD and AUD/USD may be an opportunity
By Chris Shaw
Despite the European region's sovereign debt crisis putting global economic growth under threat, the euro has held up surprising well over the past few months. For Commonwealth Bank the reason behind this is the obvious one, in that the debt crisis is not a currency crisis.
As the bank's Economist Europe, Martin McMahon, points out, the related re-pricing of European sovereign debt markets doesn't imply large euro negative currency flows. This reflects the fact most eurozone sovereign bonds are held within the eurozone.
This has helped the euro hold up well relative to most European and other G10 crosses through the crisis, even if the currency has lost some ground against the Japanese yen and the US dollar. In trade weighted terms the euro is down about 5% since the middle of the year, meaning it is roughly flat relative to where it started 2011.
The current generalised tightening of financing conditions is beginning to impact on Eurozone GDP growth, so causing the European Central Bank (ECB) to ease monetary policy. McMahon notes this is putting some strain on the euro, but he expects trade dynamics and European bank balance sheet repair should prove to be supportive for the currency in the medium-term.
McMahon views the pattern in currency markets over the past few months as reflecting typical phases of risk aversion. When the markets are in a risk averse phase the US dollar has rallied as the world's most liquid and ultimate safe haven currency. At the same time the euro has performed solidly, as it is Europe's most liquid currency.
The debt crisis in Europe is not a currency crisis because while various economies in the Eurozone have high debt levels, they are not primarily due to the existence of a single currency. This has meant the crisis may not have directly fed much into underlying forex flows.
As McMahon points out, while sovereign debt markets have been re-pricing sharply, this doesn't necessarily imply large associated currency moves as yields may simply be moving in illiquid and volatile markets.
But the fact European bond markets are repricing so sharply is a bearish development for the Eurozone according to McMahon. This is because it will force austerity, tighten financial conditions, raise questions over the health of banks and weaken the economy in the region. These factors are all weighing on the euro.
As the economic outlook softens, the ECB has eased monetary policy by lowering interest rates. This is also a drag on the euro in McMahon's view, especially as the speculative end of the forex market starts to factor in the potential for eventual contagion that could trigger a wider capital flight.
This could be far more significant, as McMahon estimates foreigners' gross claims on the Eurozone total around EUR17.6 trillion. This equates to around 189% of GDP for the region. Figures in the September quarter showed a notable reduction in Eurozone asset holdings by international investors, a trend regarded as worth watching says McMahon.
McMahon notes there are also a number of sources of potentially euro-supportive flows in play at present. An example is speculation European banks will reduce their balance sheets to meet new capital rules, which could see a repatriation of funds. As well, McMahon notes there is an existing sizable currency mis-match on the consolidated Eurozone banking sector balance sheet, which is unlikely to be left un-hedged.
At the same time, trade dynamics could work in the euro's favour, as McMahon suggests the Eurozone and current account positions in the region may move into surplus in coming quarters as domestic import demand weakens and external demand holds up in relative terms.
This all suggests no sharper euro correction should be on the cards, though McMahon notes a further deterioration in the crisis could trigger a deeper de-risking shift and so send the euro sharply lower against the US dollar.
Assuming the crisis in Europe is contained, and given the potential for further policy easing by most central banks and scope for QE3 next year, McMahon suggests any further downside in the EUR/USD and the AUD/USD in coming months may actually be an opportunity to acquire these respective units at better prices for the long-term.
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