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Which one is safer: the euro or the
U.S. dollar? Before jumping to a conclusion one way or the other, let's look
at different sides of the respective coins. We have been warning for years
that there may be no such thing anymore as a safe asset and investors may
want to take a diversified approach to something as mundane as cash. We
believe Greece has rather serious issues, but concerned investors may want to
take a closer look at their dollar holdings for potential
"contagion" risks. Let us explain...
Dollar risk...
The dollar risk hiding
in plain sight are U.S. money market funds. Just like all investors,
money market funds have been scrambling for yields. With yields on three
month Treasuries at a rock bottom annualized 0.02% as of this writing, money
market funds have had to look for riskier investments to make ends meet. Part
of the reason why T-Bills are trading at such minimal yields may be due to
the bickering on the debt ceiling, ironically causing fears of T-Bill
shortages in the market (see our analysis "Debt Ceiling Jeopardizes Dollar's Reserve Status");
but another reason may be a flight out of money market funds into T-Bills, as
investors place increasing scrutiny on the underlying holdings of their money
market funds.
So what are these riskier
investments? We encourage everyone reading this analysis to download the
latest published report of the money market funds they are invested in. As we
fear the issue is a systemic one, we won't name any specific funds. Still, to
illustrate the issue, two money market funds we recently analyzed had the
following characteristics: the first was a large institutional money market
fund with US$74 billion in assets. 4.6% of the fund is held in commercial
paper issued by BNP Paribas. BNP Paribas is a French bank with €5
billion ($7.2 billion) in Greek bond holdings. In total, that fund had over
50% exposure to foreign banks, many of them European. The second was a retail
money market fund with $1.4 billion in assets offered by a major brokerage
firm. Approximately two thirds of its assets were invested in U.S. dollar
denominated commercial paper and other short-term debt instruments issued by
European banks.
European interbank lending has
continued to have its ups and downs, so why not look for funding in U.S. markets?
It reduces European Banks' dependency on the ECB. While liquidity has been
mopped up in Europe, the Federal Reserve (Fed) has ensured that U.S. monetary
policy is financing the rest of the world - quite literally in this case.
There has been substantial backlash to the Fed's policy at the height of the
financial crisis of providing liquidity to foreign banks. Still, the
"moral hazard" so often talked about is alive and kicking: while we
don't have a crystal ball, our best guess is that should European banks face
challenges in the case of a Greek default, the Federal Reserve would step in
to support U.S. money markets - and with it - European banks. Thomas Hoenig, the most vocal Kansas City Fed President to have
dissented on Federal Open Market Committee (FOMC) decisions numerous times in
2010, is working to reform the system; amongst others, he writes in a recent
Financial Times editorial: "Specifically, money market funds should be
required to have floating net asset values, ..."
Indeed, moving away from
illusion-based accounting to market-based accounting (which includes floating
net asset values for money market funds) would do more than any recent
legislation passed to make the financial world more robust. It would mean
financial institutions would need to be less leveraged because they need to
take into account that their investments could temporarily show paper losses;
isn't that exactly what we need? Incentives to use less leverage! And aren't
incentives so much superior to regulation, as it is - in our humble opinion -
impossible for the regulators to be ahead of the creativity of bankers?
Euro risk...
Let's talk euro risk now. Just as
when investors hold U.S. dollars, investors have choices when they hold
euros. While the U.S. has a national Treasury market, each European country
has its own short-term financing instruments. Even Greece continues to
periodically issue short-term debt. The benchmark for European Treasuries are
German issued Treasuries. By all means, there are plenty of opportunities to
expose either U.S. dollar or euro denominated cash equivalents to all kinds
of risk. It may be prudent for U.S. investors to re-evaluate their U.S. money
market holdings should they be concerned about "Greek contagion."
But just as investors may flock to U.S. Treasuries in times of crisis, euro
denominated investors may flock to German Treasuries in times of turmoil. The
point here is: investors have a choice and should be conscious about the
risks they are taking on. In practice, many investors embrace U.S. money
market funds, but may shy away from the euro. Notably, of course, there is
currency risk in choosing the euro. In our analysis, the Federal Reserve may
be actively working to weaken the U.S. dollar in order to spur economic
growth; in our analysis, Fed Chairman Ben Bernanke has done so in both word
and action. But for those investors considering the euro, the choice is still
one of providing a loan to a bank through a deposit, or other avenues such as
lending money to the Greek or German government, amongst many other choices.
When the euro was approaching $1.18
last summer, we were one of the few arguing that the euro will strengthen,
and substantially so. Our argument had been, and continues to be, that the
issues in the Eurozone are serious, but that they should be expressed in the
spreads in the bond markets. Meaning that it is perfectly compatible to have
a strong euro with Greek debt selling off. It is precisely because less money
is spent and printed in the Eurozone that the euro has been able to rally.
Bernanke has testified that going off the gold standard during the Great
Depression has helped the U.S. recover faster from the Great Depression than
other countries; while such a policy is not compatible with the Fed's mandate
of price stability, such a policy may indeed spur nominal growth (subject to
various risks). What many don't realize is that someone is on the other side
of the trade: currencies of countries, or the
Eurozone in this case, that don't actively debase their currency may end up
with a lot of pain, less economic growth, but potentially a very strong
currency.
Pimco's CEO El Erian has argued that when there is a "debt
overhang", contracts get "renegotiated" -- be they personal,
corporate, municipal, state or sovereign. The key is to be positioned to
profit from the opportunities that may arise in that context. You may not
want to hold Greek debt, but how about the euro through German Treasuries?
There are other choices, such as the Swiss franc or gold, to name but two;
what makes the euro different amongst these choices is that the euro appears
out of favor with many investors; the euro may present a good value
opportunity for those that believe the currency can thrive even with all the
challenges going on in the Eurozone.
Contagion risk...
So what about this contagion risk? We
tend to disagree with both camps: those that say that all will be fine don't
respect the markets - an attitude that may be hazardous to one's wealth. On
the other end of the spectrum we have policy makers such as Jean-Claude
Junker, the prime minister of Luxembourg and "President of the Euro
Group" (the head of Eurozone finance ministers), that warn of
apocalyptic consequences potentially worse than those stemming from the
Lehmann Brothers collapse.
First, it's not in Greece's interest
to default at this stage. If Greece were to default now, the country may not
be able to get financing at palatable terms, thus forcing an overnight
adjustment of its primary deficit. As such, it's in Greece's interest to continue
to lower its primary deficit; down the road, a restructuring of its debt
(default) may make sense for Greece, as it allows the country to write off
its debt, while being able to stomach the shock that comes with default. A
default now, however, would only lead to a collapse of its banking system,
without having addressed its structural issues. A Greek default now would
mostly be a Greek tragedy, as the country might fall into chaos. Greece's
problem is not one of a strong currency (by being part of the euro), but an
inability to collect taxes combined with too many promises made to its
people, which will inevitably be broken. If Greece were to leave the euro,
tourism may be the one industry to benefit, at the expense of a collapse of
the financial system, the pension and social security system, as well as
potential hyperinflation in due course.
Similarly, it's not prudent for the
stronger Eurozone countries to cut their aid at this stage. German
exports are booming, amongst others, because of the weaker euro caused by
Greek debt worries. Germany wants peace in Europe - a key reason why the
European project was initiated in the first place; Germans have always been
paying for European institutions; they don't like it, complain about it, but
will continue to subsidize them. It's also in the interest of the rest of
Europe to keep subsidizing the peripheral countries to allow the financial
system to strengthen and better stomach a default, which may very well occur
further down the road.
In this context, the best incentive
provided for reform is the pressure of the bond market: the language of the
bond market is the only language policy makers understand. Think about the
reforms that have been implemented in Greece, Portugal, Spain, Ireland, often
with rather weak governments. And when the opposition sweeps to power, such
as in Portugal now or possibly in Spain next year, guess what: the bond
markets, not the politicians, will continue to be in the drivers' seat. In
the U.S., we believe it may play out the same way: policy makers may only
come to their senses once the bond market forces them to; except that because
of the current account deficit in the U.S., the U.S. dollar may be far more
vulnerable than the euro. In the Eurozone, the current account is roughly in
balance, making it possible to have lackluster economic growth combined with
a strong currency.
Ireland appears to be following
through in imposing losses on unsecured debt holders of Irish banks; but
because the country's entire business model is based on serving the Eurozone,
an exit from the euro is in our view most unlikely. Indeed, we are more
concerned about potential fallout stemming from any Irish crisis to the pound
sterling because of exposure of the British banking system to Ireland.
Portugal is a small country that rose to the challenge rather late; its
banking system is in decent shape; we won't speculate about Portugal's fate
here, but shall note that we believe any shock stemming from the country can
be absorbed. Spain is a different story: it's a big country with a big
economy that went through a housing bust; Spain's total debt to GDP ratio is
low for advanced economies, even if the budget deficit and unemployment are
currently high; Spain started to address issues in its banking system well
before stress tests became fashionable and is moving about as fast as
possible given Spain's history and culture. Countries have gone through
housing busts before - they are painful, but we do not believe Spain is at
risk. Italy survived the financial crisis well, and did not substantially
ramp up expenditure due to the crisis; Italy's Achilles' heel is its total
debt to GDP ratio, not to mention an ailing government; still, most of
Italy's debt is domestically owned, and the market places Italy - rightfully
so in our opinion - in a more stable category than the small peripheral
countries.
Finally, note that we believe an exit
of, say, Germany, from the Eurozone is not in the cards. A 'new Deutsche
Mark' would kill Germany's export-driven economy. The departure of a strong
country would suck money out from the Eurozone financial system, causing a
collapse. And if Germany were to leave its obligations denominated in euro as
some have suggested, it would be considered a partial default, causing
irreparable damage to Germany's cost of capital. It simply makes no sense.
Rather, we believe Germany will continue to engage peripheral countries with
a stick-and-carrot approach, just as it has been playing out.
One difference today, compared to the
"Lehman moment" in 2008, is that we now know policy makers'
playbook. We know that central banks can keep a banking system afloat, even
an insolvent one (c.f. also Japan in the '90s). The markets have also been
pinpointing the vulnerabilities. It's in that context that policy makers
should spend at least as much effort in making the system more stable as they
do in trying to convince the Greek to become German - something that
obviously will not happen. As such,
- Policy
makers should heed ECB President Trichet
advice: "it is essential for banks to retain earnings, to turn to
the market to strengthen further their capital bases or to take full
advantage of government support measures for recapitalization. In
particular, banks that currently have limited access to market financing
urgently need to increase their capital and their efficiency.
- Policy
makers must not only have credible stress tests in which sovereign
defaults are factored in as possibilities. Long-term, regulations must
move away from policies that coerce banks into holding sovereign debt.
Such rules contribute to frozen inter-bank lending markets.
- Banks
must be more transparent with their holdings, allowing investors to
judge a bank's solvency on facts rather than rumors.
There are many other measures that
can and should be taken. What is most unfortunate, though, is that the will
to reform appears to wane the moment the markets quiet down. As such, the
turmoil in the bond markets ought to be embraced as an opportunity. The U.S.
was right in aggressively bolstering its banking system, as alternatives are
orders of magnitude more expensive. Foremost, however, as Merk
Senior Economic Adviser and former St. Louis Fed President Bill Poole has
pointed out, sound institutional arrangements should be in place to make stressful
periods less stressful.
There is no silver bullet to resolve
the Greek debt crisis; indeed, it's not merely a Greek or "PIIGS"
crisis, it's a global sovereign debt crisis where the debt-to-GDP ratio in
developed countries is exceeding 100%. Rather, it will be a drawn-out
process. In our assessment, it may be a painful process, but one in which the
euro may substantially outperform the U.S. dollar in the medium to long-term.
Is the euro safe? No - that notion better be reserved for a tale in the Wizard
of Oz - but in our opinion, it's odds look better than that of the U.S.
dollar.
To be updated as this discussion
evolves, please make sure you sign
up to our newsletter. We manage the Merk Absolute
Return Currency Fund, the Merk Asian Currency Fund,
and the Merk Hard Currency Fund; transparent
no-load currency mutual funds that do not typically employ leverage. To learn
more about the Funds, please visit www.merkfunds.com.
Axel Merk
Manager, Merk Hard Currency Fund
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