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If it looks
like a duck, quacks like a duck, it just might be a duck. We are talking
about the euro: it now looks like a currency, acts like a currency,
it might as well be yet another currency. The new framework of the European
Central Bank (ECB) morphs the euro from a currency of nations to a currency
of the United States of Europe. This has major implications on how to value
the euro and with it, the U.S. dollar and other currencies.
Going
forward, as weak nations in the Eurozone ask for help, they cede sovereign
control over their budgets. In return, the ECB is ready to deploy its
(unlimited) resources to lower their respective costs of borrowing. Crucial
in this context is that politicians in the Eurozone, not the ECB, approve the
help. Also crucial is that the ECB 'conditionality' merely requires, as ECB
President Draghi puts it "broad lines, leaving
it up to the governments themselves what the precise shape is."
Many
rightfully point out that this may simply help weak countries to 'kick the
can down the road', or even to hold stronger countries hostage: think Spain
that thinks it has done enough and will 'demand' help without engaging in
further structural reform. No kidding. And indeed, the silver lining of the
high cost of borrowing has been that major structural reform was pursued
because of the "encouragement" of the bond market. But what does it
mean for the euro?
When it comes
to the U.S. dollar, British pound, Japanese yen, the respective central bank's
policies guide the short-term borrowing costs for their governments. In the
Eurozone, there's "fragmentation" as weaker countries have a
substantially higher cost of borrowing than stronger ones; in ECB President Draghi's words, the "monetary transmission
mechanism" is broken. The new policy addresses that by providing a
mechanism to have such rates converge. But he is not only imposing a rate
convergence, he is also imposing a political convergence given the
requirement that governments give up sovereign control over their budgets.
What one ends
up with is what one would expect from a central bank: borrowing costs more in
line with what the central banks like to see. Draghi
correctly points out that the new framework will only be effective if
supported by sustainable fiscal policy. But he also points out that this is a
challenge no different from the challenge of any other central bank.
There's only
so much that monetary policy can do; central banks cannot solve fiscal
problems. We can only hope that the Federal Reserve has tuned in and heeds
that advice. Fiscal issues must keep politicians busy - that's what they are
elected to do. We may not be satisfied with the state of fiscal affairs in
the Eurozone, but are we satisfied with the state of fiscal affairs in the
U.S.? In the U.K.? In Japan? The Eurozone is growing up, but that doesn't
mean fiscal challenges will evaporate.
The European
Central Bank, in its own words, has created an "effective backstop to
remove tail risk from the euro area." That is correct and justifies the
rally we have seen in the euro in recent weeks in anticipation of today's
announcement. Money has been flowing from pricey currencies that benefited
from the "everything but the euro" trade, including the U.S.
dollar, to the euro. As this new framework settles in, we expect to see further
euro appreciation.
Thereafter,
we can look at the euro like any other currency with all the good and bad
that comes with it. We don't expect a disengagement of the rather activist
approach by policy makers. As such, the currency market will, in our
assessment, remain a formidable place where the 'mania of policy makers' will
be reflected. Such activism is not good for capital allocation, but that's a
global, not a Eurozone challenge. While the U.S. is busy contemplating QEn+1,
the Eurozone will provide stimulus by lowering the borrowing cost of
peripheral Eurozone countries. If the promised sterilization of the ECB's
Outright Monetary Transactions (OMT), as the new program is called, is
implemented effectively, the U.S. Dollar might get a mighty competitor, even as
we continue to be confronted with politicians the world over ducking the
tough choices.
Axel Merk
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