Central Banks have Created a Euro Rollercoaster in Response to the Crisis
Central Banks have Created a Euro Rollercoaster in Response to the Crisis

The moment the European Debt Crisis burst on the financial scene was nearly three years ago. At that moment, the global monetary system was striving to recover from the Great Recession, but it was soon greeted by another major financial crisis, this time from across the Atlantic. Sovereign risk, the risk that a foreign nation might default on its debt obligations, suddenly became a real concern. Greece and many other member states might actually default, grabbing financial headlines daily while officials dealt with Greece’s collapse and the potential spread of contagion to other countries.

The Euro, the latest attempt at a combined currency arrangement in the region, suddenly became the focal point, as investors and central bankers alike prepared for serious devaluations of Greek bonds. Early predictions were that investors might be lucky to receive ten percent of their investment back, much less collect interest due. When a crisis of this magnitude occurs, global capital will typically rush to “safe havens”, like U.S. Treasury bonds or precious metals. This reaction is temporary, but the suddenness of the selling activity, unfortunately, can cause many more consequences down the road.

The consequence for the Euro was that it experienced a rollercoaster ride, ever since the Great Recession reared its ugly head and the debt crisis took over the reins, soon thereafter. Much of the activity has been behind the scenes, controlled by central banks around the world in an attempt to temper the reactions of global financial markets. Wide swings in valuations could bring on the collapse of other parties, as well. A gradual change to a new normalcy is the preferred path. The new era of expanded globalization has necessitated a new approach. Global capital flows between developed and developing economies have increased. Shockwaves have extended their reach.

The Euro — A success story for the past decade

The success of the Euro has astonished many experts. The chart below tells the story:
The newly formed European Central Bank (ECB) introduced the Euro to much fanfare in 1999. At the time, many hoped that the Euro would soon gain in value versus other major currencies and approach parity with the U.S. Dollar, but it soon did much more than that, soaring past parity and ascending to much higher levels. A portion of the rise was due to the economic health of the combined European Union (EU), but a great deal of the upward force was derived from actions taken by the Federal Reserve Bank in the United States (Fed).

U.S. Monetary Policy expanded the domestic money supply

The dot.com crash and the “9/11” catastrophe fueled the recession of 2001. The Fed promptly lowered interest rates and began expanding the money supply, thereby lowering the purchasing power of the U.S. Dollar. The Dollar quickly lost value relative to the other major currencies, including the Euro. To put this general devaluation in perspective, a favorite example often used is to price a McDonald’s Big Mac in different parts of the world. A Big Mac that cost $3.75 in the states in 2001 would require the equivalent of $6.00 to buy the same hamburger in Paris, France in 2007.

The U.S. central bank moved quickly to address this continuing slide in value. The Fed adopted even more accommodative policy stances and even lower interest rates, until recession struck again in December of 2007. The following chart of the trade-weighted U.S. Dollar index reveals how precipitous the fall of the dollar was over time:

The Euro achieved its zenith of $1.60 in June of 2008, but soon fell from grace when the full impact of the recession hit the continent. It made a valiant comeback, but soon, word began to leak into the press that there were fiscal problems in Greece in late 2009. The full extent of the debt debacle did not become known until May of 2010. Greece had not followed negotiated fiscal guidelines, had borrowed heavily, and had no obvious means of meeting its huge debt obligations. A massive bailout program was the only solution.

In response to the crisis, the Euro began a deep dive of its own, primarily because the extent of the problem was uncertain. Capital sought safe havens, as fear spread that other member states, i.e., Ireland, Portugal, Spain, and Italy, might have similar issues, not to mention neighboring states that depended on Europe for trade. John Taylor, the head of the world’s largest forex hedge fund, predicted $1.20 by August and parity not too long after that event. Other analysts believed a decline in value was appropriate, but not of this magnitude, nor quickness.

The situation in Europe, however, deteriorated. Riots broke out in the streets across the region. The international creditors for Greece were demanding a series of austerity measures, including cuts in government spending and tax hikes, designed to free up cash to meet debt obligations. The public at large did not accept the degree of austerity measures as necessary.

Currency traders began to sell Euros in droves. The value of the Euro versus all other major currencies dropped, but the resilient currency bottomed at $1.18 and rose to nearly $1.50, in spite of increased selling pressure. It has been in a gradual descent since early 2011, but has experienced brief moments of buoyancy whenever the global economy showed signs of recovery.

The Euro’s resiliency confounds currency experts

Currency hedge fund managers were scratching their collective heads after 2011. Nearly every fund recorded large losses during the previous year, due in part to the uncommon behavior of the Euro. Economic fundamentals move currency markets, but the Euro seemed to ignore every principle driving valuations in foreign exchange. Another catastrophe in 2011, this one in Japan, gave a clue as to what might be happening behind the scenes regarding global capital flows.

A major earthquake and tsunami swept through the eastern coast of Japan in March of 2011. The disaster caused monumental delays in global trade shipments. The Japanese Yen would surely suffer and provide a buffer for the rebuilding effort, but the Yen surprisingly strengthened. The reason was that corporations and individual investors began selling offshore investments and repatriating enormous amounts of cash back to the homeland, keeping Yen buying demand high, as well as its value.

As emerging markets prospered, investors, both individuals and private pension funds, have expanded their portfolio allocations from a traditional 5 to 10 percent to well over 25 percent in some cases. Another little known fact is that companies that comprise the S&P 500 index derive roughly half of their revenues from overseas operations. The global portfolio, so to speak, has diversified well beyond the ability of our government officials and economists to understand key capital flows and how a crisis might send ripples through our financial infrastructure.

Consequences brought on by Central Banks

The primary role of a central bank is to maintain stability of prices within their domestic environment. They have various tools at their disposal that will make changes gradual over time. Occasionally, they intervene in market activities to influence, by word or direct buying and selling, the valuation of their respective national currency. They also manage a portfolio of foreign exchange reserves that facilitate trade credit.

These reserves may include gold and typically U.S. Dollars, Euros, and Yen, the three currencies that predominate in global trade agreements. A nation must maintain balances of foreign currency at the central bank level in order to conduct trade with another nation. The presence of these balances assures the trading partner that the ability to pay for goods before they are shipped is present, at least at a national level. The manager of these reserves may change the composition of the mix, depending on the country’s trading partners or to preserve the overall value of the assets.

Over the past decade reserve managers have gradually shifted funds to Euros, away from Dollars, as the Dollar declined in value and the Euro established its reputation for being a sound and safe currency. During this same period, China has also risen to prominence as a power on the global economic stage. Shifts in foreign exchange reserve fund shares do impact currency valuations. A chart in the ECB’s most recent annual report on the topic reveals subtle changes, as follows:

As can be seen on the chart at the left, not all fund managers disclose details regarding the actual currency composition of their reserves, but an increase in total reserves would obviously place more demand on the Euro. During the crisis, however, managers sold Euros to protect the value of their assets. Capital flight actually forced the Swiss central bank to establish a floor/tying arrangement with the Euro of 1.20 to stop speculative conversions to Swiss Francs. Adjustments of this nature occur in the background and are difficult to gauge regarding their impact on daily trading.

The ECB has also had to create emergency liquidity funds by selling securities on the open market. These sales have countered various capital outflows and helped to bolster the currency at times when a drop was almost certain. Mario Draghi, the head of the ECB, has pledged to safeguard the value of the Euro, but the impact of most of his actions would only be temporary in nature. The ECB has also maintained a slight positive differential in interest rates over the U.S. benchmark rate to encourage investment inflows into Europe.

The largest boost in the Euro’s value of late, however, has come from continued quantitative easing programs promulgated by the U.S. Fed. Dubbed QE1, 2, and 3, these programs have diluted the U.S. Dollar for the past three years. In response, the Euro has appreciated.

How is the Euro faring today?

The latest rollercoaster dip and rise was driven by bailouts for the two biggest banks in Cyprus, each investing too heavily in Greek bonds. Despite the turmoil, the Euro has clung tightly to a $1.30 valuation. As the initial chart depicts, the Euro, however, has been in a negative trending direction since the Great Recession. The currency has a tendency to form downward trend channels, a reflection of central bank intervention to prevent an immediate drop to an ultimately lower and sustainable level.

Will gravity finally take over and create parity with the U.S. Dollar? Many currency experts continue to speak in these terms, but less vociferously. Interest rates are low, but banks are not loaning funds to small and medium sized firms in Europe. Nouriel Roubini, a famous economist, recently suggested that austerity was making things worse, while Christine LaGarde, the head of the International Monetary Fund, stated that, “What we need is a full-speed global economy.”

A weaker Euro, not a stronger one, is what will propel economic growth in Europe. In time, the ECB will most likely allow the Euro to weaken to appropriate levels.

Works Cited

Trotman, Andrew (2013, April 16). ECB ‘can’t do everything for everyone’, says Mario Draghi. The Telegraph. Retrieved from: http://www.telegraph.co.uk/finance/financialcrisis/9998656/ECB-cant-do-everything-for-everyone-says-Mario-Draghi.html

The European Central Bank (2012). The international role of the euro July 2012. Retrieved from: http://www.ecb.int/pub/pdf/other/euro-international-role201207en.pdf

Federal Reserve Bank of St. Louis (2013). Trade weighted U.S. Dollar Index: major currencies. Retrieved from: http://research.stlouisfed.org/fred2/series/DTWEXM

Kuehnen, Eva (2013, February 7). ECB says will monitor impact of euro strength. Reuters. Retrieved from: http://www.reuters.com/article/2013/02/07/us-ecb-rates-idUSBRE91600U20130207

Mnyanda, Lukanyo, Charlton, Emma & McCormick, Liz Capo (2013, April 16) Draghi’s pledge means more to Euro than lower rates. Bloomberg. Retrieved from: http://www.bloomberg.com/news/2013-04-16/draghi-s-pledge-means-more-to-euro-than-lower-rates-currencies.html

Villareal, Ryan (2013, April 4). BRICS kiss euro goodbye, dump foreign exchange reserves. International Business Times. Retrieved from: http://www.ibtimes.com/brics-kiss-euro-goodbye-dump-foreign-exchange-reserves-1171703

Nellas, Demetris & Becatoros, Elena (2012, November 12). Greek austerity budget for 2013 approved by Parliament. Huffington Post. Retrieved from: http://www.huffingtonpost.com/2012/11/11/greek-austerity-budget-approved-by-parliament_n_2114890.html

Holland, Kelley (2012, August 3). Euro-Dollar parity could happen: strategist. Retrieved from: http://www.cnbc.com/id/48487180

Durden, Tyler (2010, March 24). John Taylor Of the world’s largest currency hedge fund sees euro dropping to $1.20 by August. Zero Hedge. Retrieved from: http://www.zerohedge.com/article/john-taylor-worlds-largest-currency-hedge-fund-sees-euro-dropping-120-august

Oprita, Antonia (2013, April 18). Growth, not austerity, key to ending the crisis: Lagarde. Emerging Markets. Retrieved from: http://www.emergingmarkets.org/Article/3193562/Growth-not-austerity-key-to-ending-the-crisis-Lagarde.html

The Team at forextraders.com (2013, April 17). The euro is channel-bound until GDP growth for the region improves. Forex. Retrieved from: http://www.forextraders.com/forex-news/the-euro-is-channel-bound-until-gdp-growth-for-the-region-improves-92658.html

*** This article is a guest submission by Forextraders.com

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