It is no secret that the Eurozone has been struggling to control the spill-out stemming from peripheral nation’s fiscal irresponsibility. Consequently, the euro itself has been subject to downward pressure from investors moving away from the troubled region. Fear of Greece defaulting on their obligations has pushed spreads on Greek debt to record levels, while the Credit Default Swap spreads are pushing wider too. Despite efforts from the European Union, IMF and European Central Bank in the form of a recapitalisation plan for troubled European banks to ease the fear of contagion, as well as increasing the scope of the European Financial Stability Facility to buy the debt of the struggling economies, the Greek government have been unable to bring their fiscal house into order and the markets are still fearful of them leaving the single currency and readopting the drachma.
A Greece using the drachma and in control of their own monetary policy has the ability to devalue their currency to reflect the requirements of a struggling economy. A weaker currency would increase economic competitiveness and allow them to drag themselves out of the recession they are in while helping them to reduce their deficit. Additionally, they would not be bound by the required debt to GDP levels enforced by the single currency governance. Such is the freedom to support their own economy, and make decisions for themselves. Investors are aware of the potential exit from the euro by Greece, and if they go, who knows who will be next, maybe Portugal or any other of the PIIGS for that matter.
At the time of writing, the EUR/USD is trading at 1.3470, off the lows after yet another potential plan, albeit lacking any significant detail, but invariably proposes to ensure the European banking system is protected from potential contagion. The single currency bounces each time positive news makes headlines, but as soon as the optimism dissipates and the reality that the likes of Greece remain arguably insolvent, investors sell the currency and move into the perceived safety of the U.S dollar.
Notice I say the “perceived safety” of the U.S dollar. That is right – the same currency that came within touching distance of financial meltdown as U.S political leaders played a dangerous game of brinkmanship with regards to the debt ceiling. In the process, the same country has been downgraded by one of the major credit agencies. But more on the ‘safe haven’ trade later!
Since its inception, the euro has had a consistent and credible central bank in the European Central Bank that has offered investors predictable and determined handling of monetary policy – price stability. The primary mandate of the ECB is to maintain a stable rate of inflation and largely they have achieved this goal. However, no longer are they facing the singular task of fighting inflation, but with the sovereign debt crisis inducing a deep rooted fear of lending, combined with the much needed but severe implementation of austerity measures, the region is facing a period of growth below expectation, with some even whispering the ‘R’ word – recession.
In a bid to free up lending and allow the necessary room for the economy to expand there is a high probability the ECB and incoming president Mario Draghi will have little choice but to cut rates. With an interest rate cut on the horizon, coupled with the persistent threat of another peripheral nation making headlines with debt issues of their own, the single currency could well face further pressure to the downside as investors move away from the region on risk aversion flows.
When considering safe haven plays the usual suspects of the Swiss franc, Japanese yen and U.S. dollar spring to mind. During times of uncertainty and risk aversion, investors move away from the risk associated currencies including the euro, Australian and New Zealand dollars. However, the Swiss National Bank has essentially removed the Swiss franc from the equation by placing a floor underneath both the EUR/CHF and USD/CHF respectively. In doing so, traders fleeing from the Eurozone and their debt problems have had to look beyond the neighbouring Swiss franc putting the U.S dollar back in demand during times of uncertainty. The following chart clearly shows the correlation between EUR/USD and USD/CHF since the Swiss National Bank intervened.
This is an excerpt from Nov 2011 issue of Forex Journal.