Author Bio

It is only a matter of weeks since a number of European leaders, including the French President Nicholas Sarkozy and Italian Prime Minister Mario Monti, declared the euro-zone crisis to be “almost over.”  Financial markets jumped to the same conclusion following the large provision of liquidity by the European Central Bank (ECB) in two large three-year long-term refinancing operations last December and late-February respectively.

The calm provided by the ECB’s unconventional liquidity facilities proved fragile however, and stress returned to the zone’s sovereign bond markets once data confirmed that economic conditions continue to deteriorate.  The contraction in economic activity is frustrating efforts to meet ambitious fiscal goals, with both Spain and Italy indicating that they will not reach the initially projected deficit targets.  The evidence confirms that the fiscal consolidation strategy is not working, and a less restrictive policy mix will ultimately be required to save the euro-zone’s troubled periphery.

The economic challenge facing the periphery is far more complex than simply reversing the large fiscal deficits and stabilising the outstanding stock of public debt relative to GDP.  The sizable external deficits that persisted in the years before turmoil struck must be eliminated in order to stabilise the level of net external liabilities as a percentage of GDP.

The average current account deficit among the periphery increased from just four per cent of GDP in 2003 to almost eleven per cent by the time the crisis struck, which caused net external liabilities to rise to more than seventy per cent of GDP in Greece, Portugal and Spain.  Meanwhile, net payments abroad averaged three per cent of GDP in Greece, Portugal and Spain by 2007, or one-quarter of the current account deficits in each country.

By 2007, external debt indicators all vastly exceeded levels that had previously triggered crises in developing countries, and continued to deteriorate in subsequent years.  The latest available data indicates that net external liabilities exceed 100 per cent of GDP in both Greece and Portugal, are close to 100 per cent in Ireland, and more than 90 per cent in Spain.  Not surprisingly, net payments abroad are capturing an ever greater share of GDP.

In order to return the external indicators to more sustainable levels and avert a balance of payments crisis, simply eliminating the current account deficits is unlikely to prove sufficient; large surpluses will be required over several years in order to paydown external debt.  However, unlike previous balance of payments crises, this task cannot be accomplished via a substantial depreciation of the exchange rate, which means that the adjustment required can only be realistically achieved in the short-term through a reduction in domestic demand.

A decline in domestic demand however, is virtually certain to lead to a contraction in economic output in those peripheral countries including Greece, Portugal, and Spain, where trade openness is relatively low.  A fall in the overall level of economic activity makes it all the more difficult to meet ambitious fiscal targets, which means that the upward pressure on borrowing costs is unlikely to abate.  In turn, the external deficit is likely to prove more difficult to finance, increasing the pressure to effect the necessary adjustment more rapidly.

Further, the ability to run a current account surplus in the troubled countries – apart from Ireland – is constrained by the de-industrialisation of these economies in the recent past.  This means that the economic structures of Greece, Portugal and Spain are such that they can be expected to run external deficits for a ‘normal’ level of domestic demand.

The bottom line is that a sizable contraction in domestic demand will be required to return external debt indicators to a more sustainable level.  The cost in terms of higher unemployment however, is a cost that the sovereigns in difficulty may not be willing to pay.  The rate of joblessness is already unacceptably high in the periphery, particularly among the young, and further declines in the numbers employed may well lead to social unrest and political upheaval.

The external position has already shown marked improvement in the euro-zone’s periphery – apart from Greece.  The current account in Ireland has been close to balance since the beginning of 2010, while the deficits in both Spain and Portugal have narrowed considerably from almost ten per cent of GDP in 2007 to below four per cent last year.  Nevertheless, despite the impressive progress, further adjustment is required and particularly so in the Iberian Peninsula where the incremental social costs may well prove to be too onerous.

The fiscal consolidation strategy currently being applied in the euro-zone’s periphery is not working, and will continue to fail so long as much-needed private sector deleveraging and a reversal of unsustainable external deficits continue to frustrate government’s best efforts.  A less restrictive policy mix will ultimately prove necessary to save the euro.

Previously posted on www.charliefell.com

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Author Bio

Lawrence Peter ‘Yogi’ Berra, a man who earned the respect of American baseball fans first as player and then as manager, declared in the early 1960s that, “This is like déjà vu all over again” as two of his players – Mickey Mantle and Roger Maris – made a habit of hitting home runs game after game.  Berra’s words would appear to be an apt description of renewed stress in the euro-zone.

The euro-zone crisis seemed to ease following the large liquidity injection provided by the European Central Bank in two large three-year long-term refinancing operations, which led some commentators to conclude that the turmoil had come to an end.  Indeed, the yield on Spain’s ten-year sovereign debt dropped from a peak of almost seven per cent at the end of November to below five per cent in early March, while the rate available on equivalent Italian debt securities declined by more than 250 basis points over the same period.

The notion that the crisis was over was to prove decidedly premature, as the siesta was brought to an abrupt end by mounting stress in the Kingdom of Spain, an economy that is twice the size of the combined national outputs of Greece, Ireland and Portugal.  A deepening recession combined with fiscal slippage at the regional level pushed Spain back onto investors’ radar screens, and the resulting jump in ten-year yields close to the psychologically important six per cent level, has prompted onlookers to revisit the possibility that the Mediteranean country might eventually require a bail-out.

In order to appreciate the extent of Spain’s economic malaise, it is important to investigate the large macroeconomic imbalances that accumulated during the country’s long boom that lasted from the mid-1990s until crisis struck in 2007.

Spain benefited considerably from EMU membership and economic growth outpaced the OECD average in nine of the ten years pre-crisis, with the yearly increase in GDP exceeding the euro-zone as a whole by one to one-and-a-half percentage points over the period.  However, the long boom was built on shaky foundations that would be badly exposed once economic turbulence struck.

The stellar economic performance was driven primarily by a classic housing bubble alongside an ill-advised construction boom, which was stimulated by the reduction in interest rates that accompanied greater European integration.  The reference rate on home loans dropped from almost ten per cent in 1997 to just 3.3 per cent by 2007, and the resulting increase in housing demand led to a 115 per cent increase in house prices in real terms over the period.  The true extent of the overshoot in the housing market is demonstrated by the fact that price increases outpaced rental growth by roughly seven percentage points a year from the mid-90s until the bubble burst in 2007.

Strong housing demand enabled the construction market to flourish, and the resulting demand for unskilled labour contributed to a massive influx of immigrants in need of shelter, which perpetuated the cycle.  Indeed, the sustained demand for unskilled labour saw the population expand from 40 to 45 million, as the share of foreigners in the overall population jumped from just one-in-fifty in the mid-90s to almost one-in-eight at the boom’s apex.

The construction boom was fuelled not only by Spanish demand for second homes and immigrants in need of shelter, but further impetus was provided through increased home purchases by other EU citizens.  Indeed, net foreign investment in housing ranged from 0.5 and one per cent of Spanish GDP each year from 1999 to 2007.

The supply-side response to strong housing demand was nothing short of phenomenal.  The housing stock increased from 20.8 million in 2001 to 25.1 million, and the annual new supply regularly exceeded the new construction of France, Germany, Italy and the UK combined.  In fact, Spain added a new dwelling for each addition to the population over this period, such that the number of people to fill each home fell to 1.7 – the lowest in the developed world.

The bubble years were accompanied by a credit boom that saw households and non-financial businesses leverage their balance sheets to dangerous levels.  Indeed, household debt as a percentage of disposable income jumped from just 53 per cent earlier in 1997 to a peak of 132 per cent, while non-financial corporate sector debt jumped from less than 50 per cent of GDP to more than 130 per cent over the same period.  Importantly, a disturbingly large current account deficit meant that the debt-fuelled boom became increasingly dependent upon external financing, which rendered the economy vulnerable to a ‘sudden stop’ that duly arrived in 2007.

Investors’ concerns today are focussed on fiscal slippage and question marks over the true level of government debt, which many believe to be more than twenty percentage points higher than the official public debt-to-GDP ratio of 68 per cent.  However, investors should be equally troubled, if not more so, by the large private sector imbalances that have shown only marginal improvement since the crisis began.

Private sector debt remains unsustainably high, while house prices and the excesses in the construction sector will take several years to absorb.  Investors will be aware that troubled private sector debt has a habit of becoming public debt via an ailing banking system.  It’s déjà vu all over again in Spain.

Previously posted on www.charliefell.com

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Author Bio

Even if one is a short-term trader, it is worth taking a look at the longer-term chart from time to time to see how things are developing in the higher time frames. My daily work has me usually focusing on daily and intraday charts, but now and again I’ll flip over to the weekly chart to gain that broader perspective. The thing I noticed today was an interesting development on the weekly USD Index chart.

As you can see below, the Bollinger Bands in that time frame have been getting progressively narrower since about the first part of the year. They are now very narrow. In fact, on a relative basis (as shown by the purple Band Width Indicator sub-plot) they are as narrow now as they got late in Q3 last year. Notice what happened then.

Since the USD Index is heavily weighted to the euro, we basically see the same narrow-Band situation for EUR/USD as we do for the index – just with the chart inverted.  We see similar tight Bollinger set-ups in GBP/USD and USD/CHF, which isn’t too much of a surprise given how closely related those currencies are from a fundamental (and central bank) perspective these days.

The interesting thing, however, is that once you get outside the European currencies the story is different – considerably so in some cases. The narrow-Band situation actually produced a major breakout in USD/JPY earlier this year. Now we’re seeing the market consolidate after its powerful rally.

In the case of AUD/USD, we’ve got a market basically working through a sizeable range that’s been working since the highs were put in last year. We’re now seeing the market having turned down from its latest swing up, looking quite like it’s headed back for the bottom of the zone.

If we flip AUD/USD over we get a pretty close approximation of how USD/CAD has traded. There difference, though, is in the recent action. Where the Aussie has been selling off, the Loonie has been holding steady over the last couple of months.

So what does this all seem to say?

My interpretation would be this. The relatively better performance of the CAD vs. the AUD is indicative of at least the perception of the situations with the US and China respectively. These currencies are seen as closely linked via trade to their large neighbors, so as the US data has gotten better, the CAD has been supported, and as the China data has disappointed, the AUD has weakened.

Japan is largely its own situation. There is certainly some impact from China there, but mainly the yen trades as a function of two things. One is the stagnant economy in Japan, which is showing little sign of doing anything any time soon. The other is US interest rates. The correlation between USD/JPY and the US 10yr yields is quite strong as higher US rates make the yen more attractive as a carry trade funding currency than the dollar, plus more attractive for investment returns.

Then there’s Europe. To my mind, the ranging we’ve seen in the major pairs there is reflective of the markets getting a handle on where everything stands. We’re basically waiting on the next meaningful development. My guess at this point is that will have more to do with the US than it will Europe. I say that because the market seems to see the Eurozone issues as pretty clear with little change expected out of the ECB for a while. If anything the leaning is toward further loosening of policy by that central bank.

In the case of the US, though, the situation is on more of a knife’s edge. As we saw from the reaction to the FOMC meeting minutes Tuesday afternoon, there have been a number of market participants looking for another round of QE3 from the Fed (including the likes of Goldman Sachs). At the same time, though, we have others who see the US on a good sustained growth path. The USD is likely waiting to see which side is going to win that argument. How the USD Index moves out of its current consolidation will be indicative of which way that fight ends up going.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Author Bio

The seemingly never-ending Greek saga has weighed on market sentiment for more than two years, as investors increasingly questioned the troubled sovereign’s ability to repay its debt.  European policymakers insisted throughout that there was “no risk” of default, but the rhetoric ultimately proved long on hope, as the Hellenic Republic succumbed to the inevitable in recent weeks, and became the first developed country to default on its debt in six decades.

The largest sovereign default in history was greeted by investors with a mere shrug of the shoulders, a far cry from the violent reaction that policymakers long feared would bring the financial system to a standstill.  Simply put, the game has long since moved on, as investors relegated the Greek crisis to an uncomfortable but manageable sideshow, and the more pertinent question today is who’s next.

Policymakers argue that the Greek situation is a ‘unique and exceptional’ case, but such claims are certain to fall on deaf ears, given such rhetoric’s lack of credibility.  Indeed, investors have already placed Portugal firmly in their sights, and the beleaguered country’s sovereign debt has failed to participate in the meaningful downtick in euro-zone government bond yields precipitated by the first tranche of the ECB’s three-year long-term refinancing operation late last year.

Portuguese policymakers have expressed confusion at the debt market’s reaction to their seemingly heroic efforts to more-or-less meet the fiscal targets set-out by the troika in last year’s rescue package.  Indeed, the second review document published by the IMF last December revealed that the Lusitanian government managed to reduce the fiscal deficit by more than three percentage points of GDP last year to below six per cent, an impressive achievement against the background of a rapidly contracting economy.

Careful analysis however, suggests that the fiscal improvement is not as stellar as it might appear which will make it far more difficult to meet the targets for both this year and beyond.  In this regard, it is of concern to observe that last year’s effort would have fallen well short of target, but for the use of accounting cosmetics that masked the true magnitude of the underlying adjustment.

In fact, the reported deficit would have come in almost two percentage points below the desired level, but for a last-minute transfer of banking-sector pension funds to the government social security system.  This transfer accounted for almost sixty per cent of the fiscal adjustment in 2011, and removing this once-off item implies that the underlying improvement was actually 1.3 percentage points of GDP, considerably less than the ‘fudged’ reported number.

More importantly, the true fiscal position today reveals that the necessary adjustment to meet the target for 2012 is far greater than it appears in official documentation.  The deficit in 2011 – excluding the transfer of banking-sector funds – was 7.8 per cent rather than the 5.9 per cent reported, which means that the adjustment required to satisfy the 4.5 per cent target this year is more than three percentage points of GDP or two and a half times larger than the improvement implied by the unadjusted data.

The additional fiscal drag alongside an accelerating pace of domestic demand destruction and rapidly decelerating export growth means that this year’s economic contraction could well be much greater than the 3.3 per cent percentage point decline pencilled in official forecasts, which will make this year’s targets virtually unattainable.

Indeed, the year-on-year decline in domestic demand accelerated from below five per cent in last year’s third quarter to 9.5 per cent in the final three months of 2011, while export growth decelerated by more than three percentage points to below six per cent between the second and fourth quarter, as demand sagged in its major trading partners, most notably Spain.

Given the negative momentum, it is not difficult to construct a scenario in which the economy contracts by more than five per cent during the current year.  Given such an outcome, disappointing tax revenues alongside the strain on government expenditures could well see the fiscal deficit come in at seven per cent in 2012, while the level of outstanding public debt could jump to more than 120 per cent of GDP.

Needless to say, the notion that Portugal could return to the markets in the autumn of 2013 as currently envisaged under the rescue plan, would completely evaporate under such a scenario, while the pressure to restructure the Portuguese sovereign’s debt would likely prove insurmountable.

Further, it is important for investors to be aware that unlike Greece, the Portuguese crisis originally stemmed from excessive private-sector debts that currently amount to almost 200 per cent of GDP.  The large and persistent decline in the economy is certain to make a vast number of loans unserviceable, and the eventual losses incurred by the banking system could well become public debt.  In a nutshell, there could well be no option but to restructure Portugal’s sovereign debt in order to place its economy on a more sustainable path.

An ‘orderly’ debt default has been orchestrated in the case of Greece, but the insistence that it is a ‘unique and exceptional’ case looks empty as the spotlight turns to Portugal.  The negative momentum evident in the Lusitanian economy suggests that the restructuring of Portuguese sovereign debt could well prove unavoidable.  Investors should note that the euro crisis is far from over.

Previously posted on www.charliefell.com

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Author Bio

­­Our Two Cents – Week of 1/3/12

The crystal ball atop New York City’s Times Square has dropped, champagne glasses have clinked and confetti has strewn—all signs welcoming 2012. As we said goodbye to a year that saw economic commotion, we greeted the new year with a refined sense of optimism for the U.S. and equal thoughts of hope for abroad.

Americans are more confident about 2012 after what they say was a less-than stellar 2011, according to an Associated Press poll. Nearly 70 percent of Americans said 2011 was a poor year because of continuing economic crisis, and 62 percent said they were hopeful for a more positive 2012. About 37 respondents said they saw economic improvements coming within the next 12 months, and almost 40 percent believed their personal financial situations will improve. Signs that the U.S. economy is starting to accelerate are already coming to fruition. Experts say an improving job market and increasing retail sales—especially in the past holiday season—are reasons for why growth in the U.S. economy may hasten even if conditions abroad aren’t replicated. Holiday sales during the week ending Dec. 24 ascended nearly 15 percent from the same period in 2010 to $44 billion, thanks to Christmas Eve falling on a Saturday.

While the U.S. conditions are rebounding, Europe’s markets are starting 2012 on the right foot. Italy’s FTSE MIB index is up nearly 1 percent, and Germany DAX is also up more than 1 percent. Yields in Italy are down to below 6.9 percent.

In the last few days of 2011, Italy’s Treasury paid significantly less to borrow money for six months than it did a month ago, restoring some senses of economic confidence. Even though Spain has slipped into recession, the country’s inflation has eased much more than expected in December to its lowest level in 13 months. Inflation rates also relaxed in Germany for the third straight month.

Speaking of Germany, it received the highest mark on the Bank of Montreal’s economic report card of the world’s most important economies in 2011. The nation earned a score of 89.2 because of its 2.5-percent inflation rate, 7.1-percent jobless rate and 1.2-percent budget deficit. Greece closed the list at No. 12 because of its 3.2-percent inflation rate, 16.6-percent jobless rate and 5.9-percent budget deficit. The U.S. earned the No. 6 spot for its 3.2-percent inflation, 9-percent jobless rate and 10-percent budget deficit. The bank based ratings on low inflation, low unemployment and low budget deficits.

The year 2012 also observes the 10^th anniversary of the euro. While some individuals blamed the euro for causing Europe’s economic meltdown, the monetary unit could become the world’s leading single-currency alliance if leaders can succeed in tightening fiscal integration, according to one official from the European Central Bank. ECB policymaker Christian Noyer said if European officials can implement the actions from the Dec. 9, 2011, emergency summit, the union will emerge stronger.

• 2012 Is Starting Out Hot: Markets In Rally Mode For Second Straight Day, Business Insider, Jan. 3, 2012
• Euro could become world’s leading currency: Noyer, Reuters, Dec. 31, 2011
• Growth in U.S. May Accelerate Even as Europe Shrinks, Bloomberg, Dec. 30, 2011
• AP poll: Americans more optimistic about 2012 after downbeat 2011, Los Angeles Times, Dec. 29, 2011
• Retail sales resilient in final holiday stretch, Reuters, Dec. 29, 2011
• Italian Funding Costs Slide , Wall Street Journal, Dec. 29, 2011
• This Is How The World’s Most Important Economies Stacked Up In 2011, Business Insider, Dec. 28, 2011

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Author Bio

The world watched European leaders last week take the next step toward saving the euro, a move that sparked some optimism from bank officials. In the U.S., jobless claims fell to new lows, and confidence abounded from Wall Street women about alternative investments.

Applause sounded after leaders at the European Summit agreed to sign an intergovernmental treaty to enforce stricter fiscal standards in their future budgets. Efforts to get all 27 members of the European Union (EU) failed as Britain and Hungary opted out. Importantly, the 17 euro zone members agreed to the new treaty, a welcoming sign to the European Central Bank (ECB) that said the treaty would be the basis of good financial discipline moving forward. Before the summit, Standard and Poor’s warned of possible credit downgrades of 15 euro zone nations, preparing to place those nations—including the powerhouse of Germany—on credit watch negative. This action normally signals a downgrade within three months. According to S&P, the action was “prompted by [its] belief that systemic stresses in the eurozone have risen in recent weeks to the extent that they now put downward pressure on the credit standing of the eurozone as a whole.”

Also in Europe, Greece readied its next step for its bailout. Inspectors for the country’s international lenders and private credits are meeting and preparing for a new 130-billion euro bailout plan and bond swap to keep the country’s economy alive. The EU, International Monetary Fund (IMF) and the ECB—known as the troika—are visiting Athens to start preparing the bailout plan agreed in October as well as assessing the impact of debt swap plan on banks. Earlier last week, Greece approved its 2012 austerity budget as it tried to cut its debt and pull itself out of recession. Responding to the measures, many Greek youths protested, hurling stones, bottles and firebombs at police. The country’s fiscal package included some very tough cuts that will unfortunately keep many Greeks feeling cash strapped. While Greece’s fiscal matters proceeded, Hungary sought a 10-to-15 million euro package from the IMF and EU to help stabilize its economy. The country asked for assistance after its forint currency hit record weakness because of market skepticism about the government’s unconventional policies.

In the U.S., new jobless claims fell to a nine-month low, showing signs that the job market may be improving. The Labor Department said weekly applications declined by 23,000 to 381,000. Some more good news came from women on Wall Street as they planned to seek alternative investments. Nearly 65 percent of the women surveyed said they expected to find attractive investment opportunities, according to a study by the professional services firm Rothstein Kass and the international women’s group 85 Broads. More than half of the women said they planned to start new funds too.

• Greece braces for troika scrutiny and creditor talks, Reuters, Dec. 11, 2011
• Hungary aiming for 10-15 billion euro IMF/EU deal: analysts, Reuters, Dec. 10, 2011
• The euro survives … for now, CNN, Dec. 9, 2011
• New Jobless Claims Fall To 9-Month Low, NPR, Dec. 8, 2011
• Wall Street Women Optimistic About Investment Opportunities, New York Times, Dec. 7, 2011
• Greek lawmakers approve 2012 austerity budget, Associated Press, Dec. 6, 2011
• S&P to warn of downgrades for all of eurozone , MSNBC, Dec. 5, 2011

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Author Bio

The upturn in global economic activity that began more than two years ago faces a stern test of its resilience – in view of the ongoing trauma in the euro-zone – and, could well be short-circuited should the elevated stress in credit markets refuse to subside in the near future.  The financial markets have already priced in a mild European recession over the next two quarters, which the global economy should be able to withstand without too much dislocation but, such optimism could well be misplaced.

Indeed, it is not difficult to construct a scenario in which a probable downturn in euro-zone activity is more severe and, of longer duration than most commentators currently believe.  Should such an outcome unfold, strong global interdependence amongst economies virtually ensures that the negative impact on economic activity across the globe would be far more pronounced than the consensus currently anticipates.

The current cheery consensus among market practitioners is difficult to fathom given recent developments in the euro-zone and, more than likely, reflects the all-too-human tendency to overweigh the positive potential outcomes and, to place too little emphasis on uncomfortable negative scenarios.  The fact of the matter however, is that the probability of a severe recession can no longer be considered non-trivial for a number of reasons and, as a result, asset allocations should be adjusted appropriately to reflect expected outcomes rather than wishful thinking.

Euro-zone business surveys have already slipped to levels that are consistent with a contraction in economic activity but, the optimists are confident that Europe’s leadership will do whatever is necessary to contain the decline.  Such optimism appears to be based on hope rather than reality however, as both Brussels and Frankfurt appear to believe that the only road to lower market interest rates and a return to healthy economic growth is fiscal austerity – a policy prescription that is almost certain to lead to heightened rather than reduced market stress.

Fiscal austerity across the euro-zone is unlikely to appease the financial markets for one simply reason – domestic private demand is not sufficiently strong to absorb the deflationary impact.  Indeed, the elevated stress in the credit markets has already taken a heavy toll on business confidence while, surveys of lending conditions show that the banking system has become less willing to supply credit and, standards are virtually certain to tighten further, once the recapitalisation of ailing balance sheets – as prescribed by policymakers – gets underway.

A deep recession is virtually certain given current policy prescriptions and, as a result, financial market stress is unlikely to ease.  The contraction in economic output will cause tax revenues to fall short of plan and, government expenditures to exceed original estimates due to the rise in unemployment benefits.  The wider-than-expected budget deficits mean that public debt-to-GDP ratios across the euro-zone are likely to edge higher and, ensure that yields on sovereign debt remain uncomfortably high.

The optimists argue that such a scenario is unlikely to unfold, which seems to be predicated on the belief that the ECB will reduce policy rates aggressively and, ultimately purchase sovereign debt in sufficient size to ease the strain on governments.  Once again, such premises are built on hope rather than hard fact.

First, market funding costs have already disconnected from policy rates, while lending standards are beginning to show a similar dynamic.  As such, it is reasonable to argue that the stimulus to economic activity, arising from a reduction in interest rates from their current low levels, is likely to be negligible.

Second, the ECB is extremely reluctant to expand its balance sheet and purchase large quantities of stressed sovereign debt given the credit risk that it would assume.  Any sovereign that issues debt in a currency that it does not control, is simply not free of default risk.  Indeed, the Greek case clearly demonstrates to private investors that holding distressed euro-zone sovereign debt is not that far removed from owning high-yield bonds.

The truth of the matter is that the ECB is unlikely to purchase troubled sovereign debt without an ironclad guarantee that it will be compensated in the event of losses.  Such a guarantee would not appear to be on the table in Berlin and, is unlikely to be, in the absence of further fiscal integration.  This process will take time and as a result, aggressive ECB action could happen later rather than sooner.

The odds of a severe euro-zone recession are growing by the day and, it would be foolish to believe that the rest of the world would emerge unscathed given the increase in financial interconnections and trade linkages.  Indeed, one important lesson to glean from the ‘Great Recession’ is that greater global integration ensures that an economic crisis in one region is quickly transmitted to another.

Global decoupling is nothing but an old wives’ tale and, investors should note that the escalating euro crisis puts the entire world economy at risk.

Originally posted on www.charliefell.com

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Author Bio

Gyrations in the world’s financial markets have been dominated of late, by negative developments in the euro-zone.  The rolling crisis has assumed a more urgent dimension in recent weeks as, heavy selling of Italian government debt pushed yields beyond the seven per cent threshold that ultimately proved to be the point of no return for the Greek, Irish and Portuguese sovereigns.

The current turmoil has been blamed variously on the political travails of outgoing Prime Minister, Silvio Berlusconi, the large outstanding stock of government debt versus annual economic output and, the economy’s low prospective growth rate.  All of these factors have been known for a considerable length of time however, and, if truth be told, the current malaise was precipitated by the steps taken by Europe’s leadership in Brussels towards the end of last month, which were designed to ease the growing stress.

The measures backfired spectacularly however, as the facts of economic life in a poorly-constructed monetary union became clear for all to see.  The truth of the matter is that debt issued by a government in a currency that it does not control should never be considered free of default risk and, in this regard, euro-zone members are not that far removed from emerging countries that are forced to issue bonds in a foreign currency.

This harsh reality has finally dawned on the bond community and, as the pre-crisis assumption is discarded completely and, credit risk continues to be discounted in government debt prices across the euro-zone, it becomes ever clearer that the only solution to the immediate crisis rests with the European Central Bank (ECB).

In order to prevent the region-wide liquidity crisis from degenerating into a solvency problem, the central bank must make a credible commitment to employ its balance sheet and purchase the debt of troubled sovereigns in whatever size proves necessary.

Until recently, the threat of a solvency issue emerging in Italy was considered small, as the economy does not suffer from the major imbalances that were so evident in the periphery and, possesses important strengths that should have kept the wolves from its door.  These included a small primary fiscal surplus, a relatively long average life on outstanding government debt, relatively conservative non-financial private sector balance sheets and, a relatively low level of external debt.

These strengths counted for nothing however, once Europe’s leadership announced that the rules of the game had changed, which not surprisingly, precipitated a wave of selling across the region’s sovereign debt markets.

First, the large size of the haircut – fifty per cent – pertaining to the private sector holdings of Greek government debt, which is considered by most analysts to be nowhere near sufficient to yield a sustainable public debt position, revealed to investors that credit risk is very real indeed, with eventual losses expected by some to be in the region of ninety per cent.

Second, the decision to exempt official financing from the write-downs sparked the realisation that all credit losses in the event of future write-downs on troubled sovereign debt, would in all likelihood fall in their entirety on the remaining private sector investors – in other words, larger losses for fewer investors.

Finally, the large write-down of Greek debt was designed so as not to trigger credit default swap (CDS) contracts and, as a result, investors cannot expect such insurance to pay-off should further sovereign defaults occur in the future.

The yields on Italian sovereign debt have dropped below seven per cent for now, as a result of ECB purchases but, the lukewarm nature of the buying means that investors cannot be sure how long it will be before the threshold is tested again.  Indeed, media reports suggest that heavy bank selling is in the pipeline and, should yields surge higher in response to the liquidation, the less attractive Italian debt will become, as the probability of default grows.

It is not difficult to envisage a scenario in which insolvency becomes self-fulfilling.  Higher interest rates and the related market stress could plunge the economy into a sharp recession with an attendant increase in the budget deficit and the government’s financing requirement, which could precipitate a further increase in yields and so on.  To prevent such a death spiral from developing, it is absolutely essential that the ECB commits its balance sheet.

However, the monetary authority continues to object to such action on a number of fronts.  First, it is argued that an expansion of the central bank’s balance sheet would lead to inflation.  However, an increase in the monetary base – currency and bank deposits held at the central bank – does not automatically translate to a concomitant increase in the money supply.

Indeed, the traditional money multiplier breaks down at times of crisis due to an increase in liquidity preference.  Furthermore, the level of deposits held by banks at the central bank has little bearing on the credit decision, which is determined by capital adequacy and the availability of profitable lending opportunities.

In this regard, European banks already have a capital shortfall of €106 billion according to official estimates and, a credible commitment to purchase government debt may not only ease the stress on troubled sovereigns but, may also forestall a credit crunch.

Second, the aggressive purchase of Italian government debt would see the ECB assume the risk of default on its own balance sheet and, should a restructuring occur, its capital base could well be wiped out.  However, inaction could have even more dire consequences, as an Italian default would almost certainly unleash the mother of all banking crises and a deep recession that could tear the monetary union apart.

The euro-zone crisis has reached a dangerous phase, as Italy stands on the brink.  The ECB must act forcefully and act now.  The clock is ticking.

Previously posted on www.charliefell.com

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Author Bio

Europe’s technocrats announced to the world in September that they had just, “Six weeks to save the euro.”  The disturbing rhetoric was duly followed by the fourteenth summit in less than two years and, the third comprehensive attempt this year alone, to quell the rumbling debt crisis that continues to question the viability of the region’s monetary union.

The proposals agreed to at what was dubbed the, “summit to end all summits” were received enthusiastically by financial markets but, the initial euphoria was dashed by subsequent events in Greece that can only be described as farcical.

Athenian comedy aside, credit markets have had ample time to deliver their verdict and, the message emitted by debt investors is far from encouraging.  Perhaps this motley crew understands that the pro-cyclical nature of the agreed measures threatens to push the region’s economy ever closer to a deflationary abyss – absent sufficient and necessary support from the European Central Bank (ECB).

European leadership finally bowed to the obvious and admitted that the sovereign debt crisis had degenerated into a banking crisis and, as a result, accepted that the financial sector is in need of recapitalisation.  The news came just weeks after the new IMF chief, Christine Lagarde, was dismissed for daring to speak the truth, as the technocrats continued to insist that the banking sector was not short of capital.

The dramatic turnaround now sees officialdom accept albeit belatedly, that the banking sector is indeed undercapitalised to the tune of €108 billion and, has given the banks until the middle of next year to bring the ratio of capital to risk assets up to nine per cent.  Although the development is welcome, there is reason to believe that the proposal could have several negative unintended consequences.

First, the official estimate of little more than €100 billion is unlikely to ease the stress on bank funding costs for long.  The number falls well short of independent estimates that range from €200 to €400 billion, which is hardly surprising, given that the stress tests focus only on a Greek debt restructuring and, do not cater for an economic downturn that may well be in progress already.  Thus, the amount of the recapitalisation is unlikely to reassure investors, since it does not reflect the sector’s ability to absorb the losses arising from an adverse scenario.

Second, the decision to mark down all sovereign debt to market values based on prices on September 30, is likely to place a floor on yields, since lower levels would almost certainly lead to an avalanche of bank selling.  Furthermore, the negative impact on bond yields is likely to be compounded by the supposed ‘voluntary’ nature of the haircuts pertaining to the private sector holdings of Greek debt.

The fact that the large write-down on such debt is not deemed to be a negative credit event means that the market for insurance against sovereign default doesn’t really exist and, as a result, the yields on the debt of other struggling sovereigns is likely to trade higher than would otherwise be the case.

Third, it is unlikely that all banks will be able to meet the requirements via new security issuance, reduced dividend payments and share repurchases or from other cost-cutting measures.  Thus, at least some of the additional capital is likely to come from government, which would put further strain on already-stretched public sector balance sheets and, could precipitate a fresh round of rating downgrades.

Fourth, the evidence from Japan in the late-90s and, in the US at the height of the financial crisis, suggests that the plans to recapitalise the banking sector could precipitate a credit crunch and a nasty recession if sufficient monetary easing is not provided by the ECB.

It is virtually inevitable that the banking sector will attempt to meet the capital requirements through asset shrinkage rather than the sale of securities at distressed prices.  Restricting the availability of credit will push the private sector’s surplus higher and exert downward pressure on both consumption and investment, just as the public sector is engaging in fiscal consolidation and attempting to push its deficit lower.

A painful recession could well be the result unless exports absorbed the adjustment.  This is unlikely to happen however, as the rest of the world is hardly reporting robust growth numbers.  Thus, the adjustment is far more likely to be reflected in reduced imports rather than increased exports and, given that more than one-fifth of US exports are shipped to Europe and the region is China’s largest trading partner, this is the mechanism through which a euro-zone recession is likely to be transmitted to the rest of the world.

The ‘summit to end all summits’ a fortnight ago proposed a number of far-reaching measures intended to underpin financial stability in the euro-zone.  However, the pro-cyclical nature of the proposals including a bank recapitalisation plan, that threatens to push Europe ever closer to a deflationary abyss.  It’s time for the ECB to step up to the plate and employ its balance sheet.

Previously posted on www.charliefell.com

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Author Bio

August is usually a difficult month to navigate for currency traders, and this August was no exception. There are a lot of issues in the world that have yet to be sorted out and traders are having trouble determining the lesser of “two evils” so to speak. On one side, you have the USA and the downgrade in credit rating and debt issues, and the lack of decision making by the FED on what to do next. And then Europe with the PIIGS and the Eurozone crisis and all the things that need to be sorted out there. This confusion was evident in the market by looking at the lack of direction the EURUSD took in August. Some volatility was evident, but the market experienced a sideways range that couldn’t breakout of the 1.45 and 1.40 levels, which were tested but never significantly broken through. Now after the first full week of September, the Dollar rallied and broke that 1.40 level and is starting to gain traction against the Euro. We might see some retracement back to the upside but we need to keep an eye on all the numbers and the key technical levels to determine if this will develop into a longer term dollar rally or false movement. Watch for the fundamental developments of strong decision making in Europe and the ECB, or the Fed in the USA.

My plan for the market:

I am a firm believer in sticking with the strategies that I’ve had success with. However, sometimes traders get in trouble by not paying attention to certain factors in the market that could negatively affect their strategies. Since August was not a month of breakouts, we have to closely monitor price action and key technical levels of market support and resistance, as well as daily range. In August, I found that many of my targets were not reached, because of the ranging nature of the market, which is why I have exit strategies set up in case of a reversal and I certainly don’t want a winning trade to be turned into a losing trade. Also, make note that I use a tight stop loss on my trades, so there may be some losses, but they are cut short in order to protect equity and to provide a solid risk/reward ratio.

One of the things that is important is to not over-trade. With my strategies, some weeks will be lighter on volume than other weeks just depending on what the charts look like. Some traders try to avenge losses immediately or during an open floating loss. This is a setup for failure as it is best to wait until the next valid trade opportunity and not to trade off emotion. In August, I noticed that the market wasn’t ideal for one of my strategies, so as a result, I stopped trading that strategy until the market gets back to a place where I feel comfortable re-implementing that strategy.

Going forward through September, I am hopeful that the market will have a higher daily trading range and I believe that more valid breakouts and trends will form as traders begin to get a better feel for this current market we are faced with, and how the economies and currencies will be affected. I am also a true believer in technical analysis and stop trying to predict what is going to happen with an economy, rather let the fundamental developments play out which will all be translated into the technicals, chart patterns, and price levels of the currency in which we can base our trades and strategies from.

With chaos and confusion often comes opportunity. I am a firm believer in trading where there’s a trade and holding off if the market isn’t there. September’s rally out of the gate is a positive trend that I’m ready to ride.

To download Spencer Beezley’s Currensee Trade Leader profile please click here.

Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.