Thinking the unthinkable - a euro zone breakup

By Noah Barkin 26 Nov 10

BERLIN (Reuters) - Contagion spreads from Ireland to Portugal and then to Spain, forcing European leaders to exhaust the $1 trillion bailout fund they set up only half a year ago to defend their ambitious single currency project. Sniping within the 16-nation euro zone mounts and popular support for the euro erodes as German taxpayers rebel against a series of costly rescues and austerity fatigue in the bloc's periphery reaches breaking point.

Eventually one or more countries decide enough is enough and break away or are forced out, reintroducing the national currencies they used before tying their fate to Europe's audacious economic and monetary union. Unthinkable only a few weeks ago, a small but growing number of experts now believe some version of this nightmare scenario could become a reality for the euro zone if policymakers fail to unite behind a more forceful strategy for saving the euro and address investor concerns about fiscal and economic imbalances.

Until now, doomsday predictions of a euro zone breakup have come mainly from Anglo-Saxon sceptics, some of whom saw the single currency bloc and its one-size-fits-all monetary policy as fatally flawed from the very start. Over the summer, British economist Christopher Smallwood of consultants Capital Economics produced a 20-page paper entitled "Why the euro-one needs to break up" and U.S. economist Nouriel Roubini, alias Dr. Doom, predicted euro members would be forced to abandon the single currency.

But as the second wave of Europe's debt crisis gathers pace, engulfing Ireland and heaping pressure on Portugal and Spain, a new group of doubters is emerging. They believe it may be difficult for the euro zone to hold in its current form, even if many think that remains the most likely scenario. Some, like Financial Times commentator Gideon Rachman, say Germany could bolt if public frustration with bailouts mounts or if Berlin is unable to convince its euro partners to back its controversial plan for a new permanent rescue mechanism.

Dissident academics have challenged the legality of German participation in the Greek rescue in the Federal Constitutional Court. If they won, the impact on the euro could be devastating. Others see a risk that economic divergence between Europe's stable core and debt-saddled periphery could end up splintering the bloc into a two-tier "Euro-North" and "Euro-South".

Still others believe Germany could engineer the expulsion of euro weaklings like Greece that it feels should never have been allowed in. "I don't think we'll see a breakup of the euro and Germany returning to the deutschemark, but what we could see is a more homogeneous euro area purged of its low performers," said Domenico Lombardi, a former executive board member at the IMF who is president of the Oxford Institute for Economic Policy.

HUGE POLITICAL WILL
These voices still represent a small minority and few of the sceptics are convinced the euro zone will fracture anytime soon. Close observers of Europe, and the policymakers charged with defending the euro, dismiss the possibility of a breakup out of hand. They cite the huge emotional as well as economic investment in the project, the political will behind it, and the pain, complexity and humiliation an exit would bring. They point to the resilience of the euro itself, which has lost some 6 percent of its value against the U.S. dollar in the past three weeks but remains a strong, stable currency by historical standards.

German Bundesbank president Axel Weber said on Wednesday there was "no way back" from the euro, reassuring his French audience that politicians would simply come up with more money if their $1 trillion safety net proved insufficient. "My guess is that for quite a few years yet policymakers will do whatever they can to save this thing," said Katinka Barysch, deputy director of the Centre for European Reform. "If you sit in London, it's doomed. They don't understand the political investment. They look at the bond spreads and think it's doomed."

Jacob Funk Kirkegaard, a fellow at the Peterson Institute for International Economics in Washington, said a breakup remained "unthinkable" and pointed to the bloc's response to the Greek meltdown, in which, after repeated delays, it tore up the rulebook and took decisive action to stop the rot. "If the euro were seriously at risk one could expect a much more forceful response," he said. "You would see the ECB printing 500 euro notes and dropping them from helicopters before Spain was forced to default or could endanger the euro."

FISCAL UNION A NON-STARTER
Still, if the recent turbulence has proven anything, it's that "shock and awe" measures are unlikely to appease investors for long, nor change their view that the bloc is fundamentally flawed because of a steep competitiveness gap that only a closer fiscal union may be able to solve. Going down this path is a non-starter for Germany, which has insisted instead that peripheral euro countries push through deflationary wage cuts and painful structural reforms to boost productivity, in line with its own successful economic model.

The Greeks, Irish and Portuguese are going along with these policies for now, but sceptics worry that in the years to come this strategy will be exposed as deeply flawed and that destabilising imbalances within the bloc will re-emerge. The OECD predicted last week that Germany's current account surplus would rise back to peaks of around 7 percent of GDP by 2012. It forecast 2012 deficits for Greece and Portugal of 5.9 percent and 8.0 percent respectively, well down from their pre-crisis double-digit highs but still substantial. The realisation that markets may not allow the euro zone to muddle along making only minor tweaks to its fiscal rules, as it did in its first decade, appears to be sinking in among European policymakers.

On Wednesday, the finance minister of euro newcomer Slovakia described the risk of a euro zone breakup as "very real", a day after German Chancellor Angela Merkel told parliament the euro was in an "exceptionally serious" situation. "This is a systemic crisis which requires a systemic response but we haven't seen that so far," said Lombardi. "This is being dealt with on a country by country basis, first Greece, now Ireland, and you can be sure they won't be the last country."

G20 stalemate points up disruptive power shift

By Alan Wheatley, Global Economics Correspondent

BEIJING, Nov 14 (Reuters)

Economic power is leeching from the old world to emerging markets. The politics of globalisation are not keeping pace with this shift. And that makes it hard to agree joint action to tackle urgent issues such as how to reduce China's external surplus.

The Group of 20 summit in Seoul amply corroborated each of these truisms. The risk now is that, in the absence of policy coordination, a purely market-driven adjustment of global economic imbalances will be messier than it need be.

And where market forces are not allowed to prevail, as is the case with China's exchange rate, the temptation for politicians in the United States and Europe to try to force the adjustment through tariffs and import barriers can only grow.

"There is a pervasive sense that the G20 has reached the limit of cooperative efforts towards rebalancing of the world economy," said Eswar Prasad, a Cornell University professor and a senior fellow at the Washington-based Brookings Institution.

With advanced economies barely plodding along while emerging markets are enjoying red-hot growth, reconciling the different types of policies required has become difficult, Prasad said. "In an increasingly integrated world economy with emerging markets playing a prominent role, cross-border spillovers of domestic policies then set up a situation ripe for conflict," he added.

These conflicts were on show in Seoul. Emerging economy members of the G20 flailed the easy-money policies of the Federal Reserve, the U.S. central bank; President Barack Obama, beset at home by high unemployment and low growth, urged Chinese President Hu Jintao to ease the pressure on American manufacturers by letting the yuan rise faster.

But the writ of the United States in the global economic system no longer runs unchallenged.
Gone are the days when a U.S. Treasury secretary could gather four counterparts around a table and set in motion sweeping changes to exchange rates and trade positions.

In the eyes of policymakers in many developing countries, U.S. primacy and credibility have been eroded by the global financial crisis, which had its origins in the U.S. subprime mortgage meltdown.

The ultra-loose monetary and fiscal policies that the United States has adopted in response is testing faith in the dollar to destruction -- and not just among the likes of China and Russia. No less a figure than World Bank President Robert Zoellick, himself a former U.S. Treasury official, said last week it was time to start thinking about building a new monetary system.

So it is little wonder that Washington has repeatedly failed to get Beijing to do its bidding on the yuan. In Seoul, a different tactic fizzled: the G20 refused to back a U.S. plan for numerical targets for current account surpluses and deficits -- a roundabout way of applying peer pressure on China.

Instead, Hu stuck to Beijing's well-rehearsed stance that the yuan's rate of climb would remain gradual and calibrated to China's national interest. In case someone had not heard the first time, Hu repeated his position at an Asia-Pacific leaders' meeting on Sunday in the Japanese port city of Yokohama.

Stewart Patrick with the Council on Foreign Relations in New York said the Fed's recent decision to embark on a $600 billion bond-buying programme had undercut Obama at the summit. Moreover, his party's trouncing in mid-term Congressional elections had made his G20 counterparts sceptical of the president's ability to deliver on global commitments "Confidence in U.S. global economic leadership continues to wane," Patrick said.

"VICTORY FOR EMERGING MARKETS"
Illustrating how the sands are shifting, the G20 gave its blessing to developing countries such as Brazil that opt for capital controls to prevent incoming walls of cash from pushing up already overvalued exchange rates.

Not long ago, such curbs were anathema to the United States and the IMF. In another nod to the growing clout of developing countries, the Seoul summit formally endorsed a deal that gives them more power in the running of the IMF, largely at Europe's expense. "On balance, this G20 meeting was a victory for emerging markets," commented Lena Komileva, head of G7 market economics at Tullett Prebon.

The G20 is not doomed to deadlock as emerging giants try to wrestle power from advanced economies. As well as settling on a redistribution of chairs and shares at the IMF, the group agreed new rules designed to avert future bank collapses.

But the Seoul stalemate over imbalances points up the group's limitations when it is not confronted by an immediate crisis, as it was at the first G20 summit two years ago. Then, the freezing up of global credit markets and the onset of recession concentrated minds and generated a coordinated stimulus in response.

Today, divergent trade and inflation trends are leading to tension rather than policy coordination, according to economists at J.P. Morgan. "Ironically, this tension is likely to produce a desired aggregate outcome -- an easier global monetary policy setting that increases the likelihood of a strong global growth outcome next year.

"However, widening imbalances alongside inappropriately synchronised policy stances raise concern that the eventual global policy normalisation will prove far more disruptive than necessary," they wrote in the bank's weekly Global Data Watch.

In my view, this all points to a continual decline in the USD. Whatever trade you have on, do not have any part that is long USD's - KT

Position update

Policy change.
I deal with my bank and use forward exchange contracts, typically rolled out at inception for 1 year. That means I don’t really worry about day-to-day changes unless the trend itself is in danger. In the past I have shown the spot rate that I have entered deals and ignored the forward points, whether they have been a benefit or cost.

But some of these carry trades have been in place a long time, and the points are getting extremely valuable. So from now on I will show the deal at the forward rate and strip out the unearned forward points for valuation.

Here are the trades I am active in:

AUD/JPY

Long AUD 3,735,990.04 short JPY at 76.69 average.

This was originally made up of two trades:
An original deal of long USD3m short JPY @103.10 (unfrozen on 5 June 2009) and a short USD3m long AUD @ 0.8030 (yes, crossing it up with the AUD has saved me!) done on 5 June 2009, creating a cross of 82.79 average.

I have not bothered with the points on the USD/JPY leg as the interest differential was so small.

The AUD/JPY deal was rolled to 7 June 2010 at a 230 point benefit and has since been rolled again at the bank to 7 June 2011 at a 380 point benefit (as AUD interest rates have climbed over the rollovers).

So the new rate due 7 June 2011 is 76.69, but only on 7 June 2011. The unearned forward points as at today are 238 points cost, so an effective spot rate for valuation purposes of 79.07. (Are ya confused yet!)

Current spot rate: 81.35

Current: Gain 228 points

Comment:

See AUD/USD comments below.

USD/JPY:
The state of Japanese government finances remains extreme. The new government will eventually break the self-imposed debt ceiling and prompt a credit downgrade by the ratings agencies. But the weakness of the USD remains paramount at this stage, especially with QE the dominant force at the Fed. The USD/JPY will eventually test the 80.00 area, and we will see the Japanese intervene below there. I am not hopeful that they will achieve anything by intervening, but the AUD upmove itself should compensate for USD weakness.

I am happy with the current exposure, but more from a carry trade perspective, in that time works the profit out.

NZD/JPY

Long NZD 3m short JPY at average of 53.33.

The NZD/JPY deal was rolled from the last trade of 1m (making 3m in total at an average of 57.23) on 28 May 2009 to 28 May 2010 at a 160 point benefit and has since been rolled again at the bank to 27 May 2011 at a 230 point benefit (as NZD interest rates have climbed over the rollovers).

So the new rate due 27 May 2011 is 53.33, but only on 27 May 2011.
The unearned forward points as at today are 121 points cost, so an effective spot rate for valuation purposes of 54.54.

Current rate: 63.80

Current: Gain 926 points.

Comment:

See Yen comments in AUD/JPY above. See NZD/USD comments below.

I am happy with the current exposure, but more from a carry trade perspective, in that time works the profit out.

EUR/USD

Square

Current rate: 1.3690

Comment:

The ongoing concerns in Europe over debt are not going away. But I believe that it is not the problem it was back in May. The ECB can buy bonds, but at present there is a bit of brinkmanship going on. They want to teach the politicians that they have to sort out fiscal policy. Eventually the ECB will again step in so I don’t see EUR weakness as long lasting.

In the long run, all other things being equal, the Euro Zone debt position is far better than the US. If the US does not move to reduce the budget deficit over time, then the USD will become the next Greece.

I still believe that Europe will raise interest rates before the US does. Watch the inflation readings. With Gold, oil and food all hugely higher, inflation is on its way. Have look at

Standard and Poors

then expand the agriculture icon!!!!

Agriculture is up 25%, with cotton up 90%!

GBP/USD
Square
Current rate: 1.6114

Comment:
Took a loss on my short GBP1m position at 1.5278 (short from 1.4990) of USD 28,800. Took a gain (back on 11 August) on my long GBP1m position at 1.5820 (long from 1.5278) of USD 54,200. Net gain USD25,400 (NZD35,376 @0.7180).

AUD/USD

Long AUD 2m short USD at 0.7907.
Current rate: 0.9861

Current: Gain 1954 points.

The AUD/USD deal was at spot of 0.8670 on 28 September 2009. Was rolled to 28 September 2010 at a 320 point benefit and has since been rolled again at the bank to 28 September 2011 at a 443 point benefit (as AUD interest rates have climbed over the rollovers).

So the new rate due 28 September 2011 is 0.7907, but only on 28 September 2011. The unearned forward points as at today are 393 points cost, so an effective spot rate for valuation purposes of 0.8300.

Comment:

Unchanged really. I believe the Australian economy remains extremely well placed to benefit from ongoing commodity demand, especially with China still growing strongly. I expect ongoing interest rate increases from Australia. I still believe that the AUD/USD has a long way higher to go yet. My new target is now 1.0500.

Happy with the current exposure.

NZD/USD

Long NZD 2m short USD at .6745.

Current rate: 0.7730
Current : Gain 985 points.

Comment:

The NZD/USD deal was at spot of 0.7160 on 28 September 2009. Was rolled to 28 September 2010 at a 190 point benefit and has since been rolled again at the bank to 28 September 2011 at a 225 point benefit (as NZD interest rates have climbed over the rollovers).

So the new rate due 28 September 2011 is 0.6745, but only on 28 September 2011. The unearned forward points are 207 points cost, so an effective spot rate for valuation purposes of 0.6952.

The NZD/USD is still looking very positive, with commodity prices still driving the NZD higher. There is also some pressure from the Canterbury earthquake offshore flows. As the re-insurers offshore pay out on the claims they have to buy NZD’s. The sums involved are large and that is driving the NZD/EUR and NZD/GBP higher, as the re-insurers are in the UK and Europe.

The NZD/USD is still following the AUD/USD, which is driven by Asian developments. The NZD/USD has not really had the benefit of rising interest rates, but this cannot be too far away now. Inflation pressures are strong in China and Asia and we need the higher NZD to insulate us from imported inflation. When the RBNZ begins to raise interest rates in March 2011, the NZD/USD will begin to test the post float highs around 0.8250. Target remains the highs of 0.8250, but we may see the 0.9000’s before this trend finally tires.

Happy with the current exposure.

Unrealised gains NZD1,174k (AUD/JPY +134, NZD/JPY +435k, AUD/USD +404k, NZD/USD +201k).
Previous realised balance: NZD2,344,360.38

Plus GBP/USD realised gains of NZD35,376

Total gains banked since August 2007:

NZD2,379,736

So if I cashed up the whole lot right now I would have made over NZD3.5m since August 2007 or slightly over 3 years.
If you don’t believe me, scroll back through all my posts to see how I did it!!

My trading style, a repeat!

http://kiwitrader.blogspot.com/2009/06/my-trading-style-repeat.html

Ireland sneezes but little sign of globalised cold

10 Nov 2010 Jeremy Gaunt, European Investment Correspondent

LONDON (Reuters) - About six months ago, the euro zone debt crisis was hot enough to trigger headlines like "Wall Street falls on worries about Greece". It was all about contagion, fears that default in economic minnow Greece could spread not just to Portugal and Spain but beyond, crushing the euro zone in its wake. Tensions are increasing again about debt in the euro zone periphery - particularly Ireland - with some yield spreads and debt-insurance costs at record levels.

But to date there has been little sign of global contagion, primarily because investors have been looking elsewhere - mainly the Federal Reserve - and because of crisis management programmes that can now be employed by policymakers. The spread between Irish 10-year bonds and German Bunds hit a record 571 basis points on Tuesday, up from around 300 at the height of the crisis and a good 200 above where it was in mid-October.

Greece, too, is back up to uncomfortable levels, if not as wide as at the height of the crisis, and Portugal's spread has widened to a record as well. The impact further afield, however, has only been felt mildly so far, mainly on the euro, and even then only in the past day or so at a time when the dollar has been rising broadly anyway. "Markets fear of contagion has fallen," said Klaus Wiener, head of research at Generali Investments in Cologne. "In May, the escalation of the debt crisis in Greece threatened to end in a systemic crisis. This fear is not as pronounced any longer." The 30-day correlation between the movement in peripheral bond spreads and the euro was around -0.6 in May, meaning that widening in spreads was usually matched by euro weakness.

That correlation is now close to zero for Ireland and only slightly negative for Greece, suggesting that at least over the past month the debt problems have been isolated, having little if any impact on the currency. It is more or less the same story with stocks. In the past three weeks as the Irish spread has widened 200 basis points, the pan-European FTSEurofirst 300 stock index has gained more than three percent. It was up three-quarters of a percent on Tuesday as the spreads widened to another record.

Globally, stocks have paid even less attention, with MSCI's all-country world index rising around 4 percent over the period. Data from iTraxx, meanwhile, shows that investors are pricing in the chances of default in European companies as less than that for Western European sovereigns -- not good news for sovereigns but hardly a thumbs down for corporates, which suggests fear does not stretch to a systemic crisis which would surely engulf companies as well.

DIFFERENT CONDITIONS
There are two main reasons why the market impact from the renewed debt worries has been muted so far. One is simply that investors have had their minds on other things, notably the $600 billion quantitative easing programme launched by the Fed last week to stimulate the U.S. economy. The global economic picture has also improved, with even lagging U.S. jobs creation ticking up. "The big theme was quantitative easing, the economic cycle. It is undeniable that the data has been positive, almost globally," said Joost Van Leenders, investment specialist at BNP Paribas Investment Partners in Amsterdam.

The second big reason is that investors believe lessons were learnt in the earlier Greek crisis and policymakers stand ready to stop disorderly default contagion. Since June, a European stabilisation mechanism has been in place, funded by the European Union and International Monetary Fund, to provide as much as 750 billion euros at relatively low interest rates to euro zone countries needing them. No money has been taken, but it is seen by many as a safety net. There are also plans afoot to create a permanent mechanism. Although political differences will make agreement hard, the mere fact that it is under discussion underlines the willingness of authorities to act. None of this is to say that the current stresses in Ireland and elsewhere are negligible. It is inconceivable, for example, that a default or restructuring in Greece or Ireland would not have wider impact.

But the lack of sharp reaction outside the countries concerned so far does suggest investors are not expecting a blow up across markets similar to the one earlier this year.

Normal transmission has been resumed

Sorry, been away doing other stuff. Back online now!