Is the Market Confusing the Euro with the Drachma?

Harvard Professor Martin Feldstein and member of the NBER committee that is the official arbiter of US recessions was on Bloomberg TV today suggesting that the the euro's decline this year was a reflecting of unjustified panic over Greece.

While of course the concerns about Greece and the lack of sufficient institutional capacity was a important drag on the euro, there seems to be something else at work. Greek bonds have been steady to higher for the better part of the past two weeks and the euro remains stuck in relatively narrow trading range that has prevailed since at least the middle of February.

The lack of a stronger euro bounce, especially given the fact that short-term speculators, model driven, trend followers are thought to have broadly participated. The Commitment of Traders shows that non-commercials (speculators) had built record net short euro positions and have barely pared it back in the most recent data.

Feldstein expresses surprise in part because the euro zone has a better trade balance. Yet the real surprise is that when you scratch many free-market economists, you get a mercantilist interpretation. Adam Smith tried, apparently in vain, to explain why exporting more than one imports is not the key to the origin of the wealth of nations.

Moreover, in the modern era, capital flows exceed trade flows by a huge margin. Capital flows rather than trade flows can help explain why the euro has declined against the dollar. Perhaps part of the problem is that Feldstein and others think the US dollar should fall and to the extent it doesn't the market is being irrational.

Feldstein argues that the euro should be regarded more as a Deutschemark rather than a drachma. " There's in my judgment, no real reason why the euro should have sold off, overall. After all, Germany is not at risk. France is not at risk."

Reasonable people can differ. As we argued last week ("Germany: An Unnamed Co-Conspirator) and Martin Wolf argued in the Financial Times yesterday, a restructuring of the Mediterranean economies has serious implications for Germany and its trade surplus Feldstein and many others, focus on the responsibility of the deficit country to adjust--hence their negativity toward the US outlook--but what they do not grasp is the interconnectedness between the debtor and creditor and the impact on the latter.

There are another reasons why many expect the dollar to continue to strengthen against the euro. To briefly sketch this out here, consider that the economic contaction created what the Fed calls slack resource utilization thoughout the industrialized countries. Whomever closes that output gap--the difference between actual and potential GDP, will likely have higher real interest rates, support for earnings and profits and would likely attract portfolio and direct investment flows.

One need not make any bold GDP assumptions to arrive at the conclusion that this most likely will be the US. The consensus forecasts and/or IMF forecasts will suffice.

Also in the Feldstein, et.al. currency views there is no meaningful role for relative competitiveness as reflected by measures like unit labor costs. We have argued that behind the Mediterranean debt and deficit issue is a larger and more significant competitive challenge. Essentially those countries have allowed unit labor costs to rise significantly relative to Germany. The US hasn't. The combination of a dollar that is still cheap relative to value (PPP models and the like), rising productivity, and the near chronic threat of protectionism, on top of the output gap outlook, is the backdrop for not only portfolio capital inflows into the US but direct investment as well (cross border M&A activity).

Lastly, in terms of imbalances, the US and China imbalances have been roughly cut in half as a percentage of GDP. A major imbalance that persists is the one inside the euro zone. What Feldstein and others see as a surplus obscures significant current account deterioration outside of Germany. They also may be confused if they think that Greece's problems, or Spain's are not Germany's problem too.

Turky and IMF End Aid Talks

In a long engagement, Turkey and the IMF have been negotiating a stand-by package for well over a year. Today Turkey announced that there would be no marriage afterall--no deal. The impasse appeared to be over municipal expenditures. PM Erodogan's government had previously negotiated two programs with the IMF since coming to power in 2002.

There is disappointment in some quarter of the end of the protracted talks as some suggest the talks themselves had lent support to the lira and the bond market. As noted yesterday, the poor inflation news at the end of last week, coupled with the heightened political anxiety and withholding tax uncertainty have weighed on Turkish bonds. Yields yesterday rose to their highest for the year amid a lukewarm reception to the bond auction and there is follow through selling today.

Turkey does not have a long-term bond. It's benchmark 2-year bond yield is at 9.52%, up 6 bp today. For the year to date, the yield has risen 33 bp, the same as Portugal's 2-year bond and well behind Greece's 133 bp increase this year. Portugal's 2-year yield remains a lowly 1.75%.

The euro has fallen about 2.5% against the lira year-to-date and currently is trading near TRY2.092. Buying 2-year Turkish bond and selling the 2-year Portugal bond bond against it picks up 775 bp annualized. The risk of course on such a trade is that the euro rises against the lira. A roughly 5.5% euro rise would bring it to the 61.8% retracement of the decline recorded since late November (~TRY2.2150). More immediately, the TRY2.12 area may cap euro uptick.

Our correlation work suggests that euro-dollar and euro-lira are not tightly related. The correlation (conducted at on the basis of percent changes)was about 33% last year and has eased to about 25% this year. That said, our bearish outlook for the euro may limit the euro's ability to rise against the the lira, making the "buy Turkish 2-year against Portugal 2-year" an interesting trade idea for some medium term investors.

ECB and Greece

Bundesbank President Weber has been the most candid to date about what the ECB could do in case Greece is downgraded again, especially by Moody's. Recall the problem: Prior to the crisis, the ECB would take as collateral only paper rated A- or better. During the crisis they have extended it to BBB-. It is due to revert back at the end of the year. Fitch and S&P rates Greece below A-, leaving only Moody's above the normal threshold.

The ECB seems to loathe to postpone the return to normalcy again. And yet as Austrian central banker Notwotny pointed out earlier this week, it seems unfair and untenable that a single rating agency determines whether a sovereign has access to the ECB's lending facilities.

A solution, Weber suggests, could be that the ECB accepts the lower quality of collateral in exchange for a larger discount--or what the market calls a haircut. There is precedent. For example, some non-sovereign securities used as collateral are given a 20% haircut.

Weber acknowledges this is not the only solution, suggesting that this is a dynamic situation and the ECB has not made any hard and fast decisions. At the same time, it indicates that although many ECB members, like Weber himself, are insisting on a narrow construction of the Maastricht and Lisbon Treaties, it is not above using monetary operations to assist fiscal objectives.

For example, some of the 12-month money the ECB provided at 1% appears to have been used in part to finance the purchases of European sovereign debt. Indirectly, but no less significantly, the ECB helped support the weaker credits in Europe. On July 1st the ECB's 12-month massive 442 bln euro provision expires. The ECB will seek to smooth this out by offering 6 month funds at the end of March and then a special tender at the end of June.

Meanwhile, reports suggest that Greece has made an early preliminary report to the EU (due March 16th) that claims that it is ahead of schedule in implementing its austerity measures. It is said to acknowledge that, as we pointed out, Greece's 2009 GDP was revised lower and that this lowers the 2010 base. Accounts also suggest that report notes that civil servant wage cuts will will crimp consumption. This is one of the ironies. Efforts to address the structural deficit risks adding to the cyclical deficit.

The markets have responded favorably to these developments and Greek bonds and the other weaker credits in the euro zone have rallied. Ten year yields are off 2-4 bp and credit default swap prices have eased. Note that current market conditions appear favorable for new issuance and there is already talk that Greece could come back to the market as early as next week to raise more funds. Last week's bond sale and the next ones, are part of the official effort to pre-fund a good part of the more than 20 bln euros in maturity and coupon payments due in the April and May period.

The euro has also moved higher on the news. Resistance at yesterday's high near $1.3635 needs to be overcome to spur a retest of the week's high near $1.3705. While many would like to see a near-term euro bounce to sell into, the shallowness of the upticks, given the more positive developments in Greece, over the past week disappoints.