Wednesday, 4 January 2012

Back to Normal. Weaker Euro. Risk Rally

Back to normality?
It's boring out there. And it is perhaps the best piece of news in a long time. After reaching a crescendo in early December, the amount of headlines dealing with the euro crisis is now in a clear decline. I choose to take it as a sign that the ECB's three-year money has stabilised both inter-bank market and the demand for government bonds from Italy and Spain.

More bad news is certainly still possible. As an example, I expect that a major European bank or two will go belly up, as no decisive action is yet taken at a European level to clean up the banking sector. But a collapse or two is probably already built into the soaring risk premiums in financial sector shares. It is more and more urgent to get EFSF and ESM up and running.

A weak euro is a strong euro
I have always wondered a little about the media fixation on the positives of having a strong currency. It smells so badly of Neanderthal nationalist policies (or of man-talk in the locker room), especially when looking at the headlines in recent months. As if it was negative to have a weaker euro!

Since the beginning of the crisis, several countries have profited from a weakening of the currency: USD, GBP, NOK, and especially the SEC. These countries all have central banks and finance ministries able to act quickly. The Euro-zone's institutions were too slow and the result was that the euro strengthened, together with CHF and JPY. This moved growth from the Euro-zone to the countries with weaker currencies. So I can only see it as good news if the EUR / USD were to trade at par. It has been there before, and it was not the end of the world. (My colleague Frank Jensen says: “It will be no surprise if EUR strengthens in the short term as a result of short-covering”. Go figure!)

Back in 1992 we saw the last major crisis in the European Exchange Rate Mechanism, when GBP fell out of the ERM and we had a wave of devaluations against the Deutschmark. Italy devalued by almost 30 percent. That crisis began with a dramatic weakening of the dollar, and it revealed the tensions in Europe. The current euro crisis is similar to the situation at the time - but now we do not have devaluations as a means to remove those tensions. A weakening of the euro will reduce tensions significantly.

Risk Rally
New Year has brought the traditional amount of forecasts for this and that. Obscurity will mercifully descend upon most of them. So let me give my own anti-forecast: If we are moving towards a normalisation of the conditions in Europe, and if risk premiums have finally stabilised, there will be room for a significant shift in the relative prices of the different classes of risk assets. Some will rise dramatically (shares? Bank shares?), while some will fall with a bang (Bunds, T-bonds?). It could conceivably happen in 2012. There are just 241 things that need to be in place first.

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