As the Eurozone prepares for another bailout/rescue summit, December 2010 seems like a long time ago. On December 3 the European Central Bank (ECB) had engaged in enough bond purchases in Portugal to knock a massive 55 basis points off its 10-year bond. That brought the yield all the way down to 5.85%. Now it is ensconced above 7.5%, well ahead of the 7% threshold that most believe signals an unsustainable interest load.
If the interest cost on the 10-year is not concerning enough, yesterday’s two-year bond auction came in at just under 6%. That compared to its previous two-year bond auction of 4% (a near 50% increase in cost).
Portugal is not alone. Moody’s is still picking on poor Greece, with a three-notch downgrade on March 7, 2011. Perhaps the near 15% unemployment was enough to persuade them that Greece will not survive without major restructuring (not bailouts!). Greek 10-year bond yield are now about 12.75%, a level that is very dismissive of April 2010’s ECB promises and assurances.
Fitch got into the action by cutting its outlook on Spanish sovereign debt to negative. Spanish 10-year bonds are now about 5.5%.
The Emerald Isle, after its bailout, still sees 10-year yields closing in on 10%. The new Irish government may end up challenging the bailout’s forced austerity, perhaps offering another opportunity for “chaotic” debt restructuring.
Italy sees itself entangled in the Libyan mess, both in terms of oil usage and financial businesses. Certainly the Euro-era record gasoline price of €1.624 per litre is partially related to the cross-deterioration in the Libya-Italy symbiosis.
With all of this evidence of clear fiscal and monetary deterioration the euro is certainly approaching parity with the dollar, right?
In the time it has taken the Portuguese bond yields to blow out (since early December) the euro has significantly strengthened against the US dollar. After moving below $1.30 per euro, the currency conversion is now just shy of $1.40, a move of almost 8%.
While this is nothing conclusive in and of itself, there is much implied in the relative state of investing in both areas. While the Eurozone has seen peripheral default risk rise measurably, the United States has begun to enter an inflationary cycle not much different than 2008. Marginal investors now favour investing in a currency that was almost left for dead in June 2010, which says a lot about where these currency players see relative opportunities.
In terms of economic and currency risk, the swings in investment flows seem to be pointing to an impending interest rate correction on the western side of the Atlantic. If currencies are derivative proxies of interest rate differentials, then the euro-dollar cross says that interest rates in the US are far too low. In fact, the danger of inflation in the US is now perceived to be greater than the perceived danger from default risk seen in the PIIGS.
This relative equation should be concerning for investors on both sides of the Atlantic. The most pressing American implication is simply that bond yields throughout the global system are too low relative to true risk. If inflation has become enough of a potential hazard to send credit investors to Europe chasing the debt of clearly insolvent countries, the entire risk/reward foundation has been skewed too much by monetary intervention.
For Europe, the proposition for credit investors is that the ECB is seeing its credibility shrink by the day. The massive bank bailout of May 2010 was supposed to be enough to end all this madness. The Greek and Irish bailouts (which were not supposed to be needed in the first place) were sold as definitive stabilisation plans. If the bank “stress tests” of last year already restored investor confidence, why are new tests (with country specific definitions for Tier 1 capital) being ordered?
At some point these farcical proceedings create enough doubt that investors pack up and go home – and in most cases that home is gold, silver, and anything that cannot be shorted, duplicated or hypothecated. Perhaps the biggest lesson of the euro/dollar relationship is that both sides are in such sad shape the real price of the exchange is literally somewhere between zero and infinity.
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