The weak euro, the strong dollar and the new global crisis

By Antonia Oprita

With elections in Greece stealing the show, investors would do well to keep an eye on the weakening euro and the strengthening dollar.

The re-balancing of the exchange rates of the world’s two main reserve currencies could have painful consequences for many countries and markets.

Already, the European Central Bank (ECB) had sent the euro to an 11-year low versus the dollar when it announced last week that it plans to buy sovereign bonds as part o its programme to kick-start growth in the eurozone.

The capital flows anticipated the ECB’s move to some extent. In the week ending on January 21, European equities saw their strongest inflows since June 2014, totalling $2.3 billion, and momentum was strong, according to Bank of America Merrill Lynch.

European equities before Greek election

European equities were on an upwards momentum before the Greek election. Source: Bank of America Merrill Lynch

However, assets perceived as risky such as emerging markets equities and debt and high-yield bonds remained out of favour. Over the past 10 weeks, a combined $50 billion exited these asset classes. This is a sign that investors are still worried about the effects of the changes in central bank policies on markets.

Sentiment towards Europe was helped by “fatigue” with the consistently high valuation of US stocks and the lack of upward revisions to earnings or GDP in the US, as well as investors’ belief that the macroeconomic situation could take a turn for the better in Europe, the Bank of America Merrill Lynch analysts said.

But that could be short lived. The victory of left-wing Syriza party in Greece, although expected, will likely push capital out of European assets.

If Syriza governs alone, without the help of a coalition, uncertainty about the fate of the negotiations with the European Union regarding Greece’s debt will be very high.

A sure victim of this would be the euro, whose weakening momentum would accelerate. There just is too much pressure on the single European currency right now, so the natural trend is downwards.

The good news would be that a sharply weaker euro will make the eurozone – even the periphery countries, Greece included – more competitive. It will, in time, spur inflation and reduce debt by stealth – inflation has always been the best way to erode debt.

The future trouble spots

The bad news is that the good news may not matter. A sharply stronger dollar could unleash a global crisis.

Last November, investment advisory firm CrossBorder Capital warned that the end of the Federal Reserve’s quantitative easing could starve the world of $10 trillion in liquidity, or about 10% of the global liquidity pool.

This would be equivalent to the net contraction of liquidity suffered during 2008-2009 and 1996-1998.

A recent paper by the Bank for International Settlements (BIS) highlighted the fact that the amount of loans in US dollars to global corporations outside of the US totalled $9 trillion in June 2014. That’s 13% of global GDP ex-US, warn analysts at Societe Generale.

Looking at the hotspots highlighted by the BIS paper can help investors identify where the future trouble could be, geographically but also by sector.

So what are the areas where most of these loans can be found?

“The top three stocks of dollar credit are in jurisdictions that are not usually thought of as dollarised: the euro area, China and the UK,” according to the BIS paper.

But since the crisis, the growth of dollar credit to the eurozone and the UK has slowed, while it has accelerated to emerging markets, where interest rates were higher, as investors looked for yield.

Non-bank investors have given “an unusual share” of dollar-denominated loans to non-US residents since the financial crisis, via the international bond markets.

While banks stepped back as holders and issuers of bonds, “non-bank investors have not only bought all the net increase in bonds outstanding but taken up the bonds that have come out of bank portfolios.”

“Given the low expected returns of holding US Treasury bonds, investors have sought out and found dollar bond issuers outside the US, many rated BBB and thus offering a welcome credit spread.”

This is a big reason why some policymakers are now increasingly uneasy with the sharp weakness of the euro and the fact that the ECB has joined the currency war.

The rapid appreciation of the dollar since the Fed ended its quantitative easing has already caused some friction in emerging markets.

If the dollar strengthening accelerates further, it could pose serious threats to financial stability.

Some countries could even find themselves in a situation similar to that of scores of hapless borrowers in Central and Eastern Europe, who had taken loans in Swiss franc at a time when the Swissie was depreciating.

Now, after the Swiss National Bank’s abrupt removal of the peg of the Swiss franc to the euro, they struggle to pay back loans they took in Swiss francs – a currency their countries do not control.

For those borrowers, the respective governments are working with the local banks to find solutions.

But if the scenario repeats itself on a global scale, with countries instead of individuals and the dollar in the role of the Swiss franc, it would be nearly impossible to find a solution.

Perhaps this is why, although there is plenty of talk of deflation, inflows into precious metals were the highest, last week, since August 2011.

@AntoniaOprita

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