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ICYMI, parts 1 & 2 of the FX Series 👇
We ended the Safe Haven section by saying...
We'll take a proper look at the Euro & why it's used as a funding currency but doesn't really deserve safe haven status...
Why the Euro isn't a safe haven
In short: Politics...
- There's a mish-mash of 19 countries/economies using the common currency
- Those 19 countries are often called the Eurozone (EZ) or Euro area
- The European Union is a dysfunctional bureaucracy comprising 27 countries.
As individual economies, their economic interests don't always align.
For example, it's widely accepted that because peripheral EZ countries such as Italy & Spain cannot devalue the currency, their wage growth is depressed to increase competitiveness.
Arguably, the main benefit of the single currency for peripheral members is the low borrowing costs that the ECB ensures (most of the time)...
David's article there 👆 is full of EZ background and this snippet gets right to the heart of the matter 👇
For a single currency union to survive in a specific geographical area, there needs to be sufficient wage flexibility and labour mobility, sufficient price flexibility and capital mobility, a fiscal mechanism for redistributing resources from regions with trade surpluses to those with deficits, and for the different areas within the union to have broadly similar business cycles.
The reality is different. Varied business cycles and inadequate labour and capital market flexibility within the Eurozone mean that systematic trade surpluses and deficits develop.
To deal with these trade imbalances, the more efficient economies in the Eurozone, such as Germany, need to recycle their trade surpluses back to deficit regions using fiscal transfers in order to keep the Eurozone economies in balance.
This is done via the Target2 mechanism, since there is no official method to redistribute these surpluses across the bloc (yes, a big failure in the design).
So we are left with the solution also being a problem.
To be able to rectify the issue, fiscal and political union would likely have to be enacted.
But there's really no appetite for this kind of full union between member states.
National sovereignty is still highly valued.
So, what's the solution?
Why can't the EU just become the United States of Europe?
It worked for the USA...
Jean Jacques Rosa explained this in his incredibly prescient 1999 book:
Euro Error 👇
Summing up, the ever-present backdrop of political uncertainty does not make for a good safe-haven.
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Is the Euro a funding currency or a pro-cyclical currency?
Let's explain 👇
Since the March 2020 Dash For Dollars (red line) the Euro and the Australian Dollar have moved broadly in the same direction against the dollar.
This was perhaps driven by hopes for a stronger economic outlook for Europe.
The €750bn Coronavirus pact reached between member states, and the first issuance of common EU debt (Corona Bonds) spurred hopes for a brighter future.
There was also talk of Germany releasing their fiscal debt brake and increasing spending (which would filter through to other EZ nations).
This has not materialised.
So... More pro-cyclical or More funder?
As a rough guide:
- If there is general positivity about the EU economy, then the Euro can still behave like a cyclical currency and benefit from global economic trends.
The longer the low-growth, low rates environment continues, the more that view becomes entrenched.
Which makes the Euro generally more attractive as a funding currency, and will likely lead to increasingly similar behaviour to JPY...
HSBC highlighted the shift in a note earlier this year:
- A clear trend since 2015 of domestic capital exiting the region in search of higher yields
- Is a consequence of the ECB’s quantitative easing programme and shift to negative rates
- "Signs that rates may be lower for even longer could encourage these outflows to continue, or even exacerbate them,"
- "This is the same pattern seen in some of the safe haven currencies such as the JPY and CHF,"
HSBC also noted the weaker justification for cyclical vs haven/funding... 👇
- "For many years, the EUR was seen as a cyclical play, which benefited from strong global growth. However, the last decade or so has seen overseas asset accumulation outstrip inflows from foreign investors."
- "This could start to change the way in which the EUR behaves. One rationale for the safe haven behaviour of the likes of the CHF and JPY is that they have sizeable foreign assets that can be repatriated during times of crisis,"
And, as JPMorgan note here, the Euro makes an attractive funding currency for EM trades 👇
The euro is particularly suited to funding investments into emerging market currencies due to the natural hedge against movements in the US dollar, which tends to drive capital flows into and out of emerging market assets
Summing up: Yes, it's both. Increasingly the Euro is more of a haven/funder than a cyclical currency.
Next in the series, the proper cyclicals and higher betas...
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