Fiscal disunity mires euro as US$ buoys slightly

Conflicting social, political and economic priorities are fighting for dominance in the Eurozone, and managing director and head of currency management at SSgA, Collin Crownover, believes this is affecting the outlook for the currency, while the US dollar, in a relative sense, looks quite positive.

The conflicting social, political and economic priorities of the individual countries in the Eurozone are providing some pretty interesting viewing for observers.

Sharing a common currency is one thing but, the conflicting priorities, cultivated by history and culture seem to still very much dominate the political motivations of the individual countries.

State Street Global Advisors’ Crownover says there is no release valve for the currency to let off steam in the Eurozone.

“It used to be common for example in southern Europe to have depreciation like the lira, but now the adjustments have to happen in the real economy,” he says. “Germans have spent a lot of time making their labour markets more flexible, they support the euro but not at any cost.”

What should happen in the Eurozone is probably a different thing to what will happen.

“There is no way around the fact that Greece is insolvent, and Ireland and Portugal are on the fence. Spain and Italy are not huge problems, but this could snowball,” he says. “At each stage the euro policy makers do just enough but don’t put a floor on it. Economically they should but there are political considerations, and German elections are imminent. Germany has to be part of the solution, it won’t happen until after the elections.”

Crownover says at the time of the creation of the euro, some of the founders recognised it was an imperfect agreement but it’s what was achievable at the time.

“The euro doesn’t qualify as an optimal currency, it’s not even close,” he says. “A better option would have been to unite countries with similar profiles, such as the Netherlands and Germany, and then other countries could join as they become suitable.”

There are lessons from history on why the euro as a currency is not ideal, Crownover says, pointing to the UK pegging the pound to the deutschemark at a time when they were very different economies.

Crownover predicts the final solution for the euro, ultimately, will be euro bonds.

“Merkel’s choice is between large fiscal transfers or euro bonds, she will choose the bonds,” he says, adding they will most likely have two grades.

Up to 60 per cent of debt to GDP ratio is a blue bond, and above 60 per cent is red which will have much higher rates of interest.

“This is a good choice for Merkel as it instills the fiscal discipline that Germans like, but doesn’t make them ultimately liable.”

Needless to say SSgA is negative on its outlook for the euro, although Crownover says it is puzzling how the euro has stayed so strong, as well as the lack of political will to address the problems.

“You can only kick the can down the street for so long,” he says.

What is probably more surprising is that SSgA is slightly bullish on the US dollar.

“Currencies are always a relative game. There are problems in the US, but compared to the eurozone, Japan and UK, the US dollar is among the major currencies I like.”

The US dollar is not in trouble, he says. The dollar rallied, like US Treasuries, around the S&P downgrade and quantitative easing increased the supply, and the US dollar is now at of pre-crisis levels.

Generally Crownover says there are a lot of mispricings in the currency markets, which are at greater levels than before the GFC.

He says the Australian dollar is 35 per cent overvalued against the US dollar, and against a basket of other developed countries, it is about 30 per cent valued, which is an all-time high. Other commodity-driven economies’ currencies, such as the C$ are also overvalued, he says, with the Canadian dollar about 20 per cent overvalued compared to the world.

The Swiss franc is also “majorly overvalued” and has had a lot of volatility, where usually it is a very “quiet” currency.

“The three currencies that tend to draw the most flows in risk-averse environments are the US$, Swiss franc and the Japanese yen,” he says. “Investors are reluctant to buy the US dollar because of the economy, and in Japan coordinated intervention has meant investors are wary to push the yen, so flows to the Swiss franc (and gold) have been greater. The Swiss franc is not that liquid, so when investors want to unwind it may be difficult to get out.”

Nonetheless it is an interesting time for the likes of US investors, which have not historically hedged their currency.

“Historically they didn’t have a large offshore exposure, whereas now they have about 30 per cent of investments offshore, so it is a huge change in risk terms. There is a misguided belief that currencies are diversifying, for US investors that’s not so, as the US dollar is a safe haven so offshore currencies decline at the same time as equities markets.”

He is communicating to investors how much of the gains in their overseas investments had come from currency moves.

“In 2002-09 US investors in overseas equities made 49 per cent, but 46 per cent came from an increase in foreign currencies against the US$ – if it can go up 46 per cent, it can go down 46 per cent,” he says.