The EU, the US Empire and the Yen

* EU update: Over the past few weeks, the recent trends in financial markets has stopped, and corrected by a modest amount. The Euro, which led risk assets lower, managed to stop on a dime around 118, a level the technical market analysts had on their maps when the Euro was in the 130s, see the first attached graph. To put things in perspective, the Euro, which can be traced back in time via a melding of its components, shows that the Euro is in a multi-decade trading range. The second graph, which goes back in time to 1975, includes both the weak and strong contributors to the Euro. In comparison, the Swiss Franc, as a strong European currency to compare to, has been appreciating since the 1970s, and this is probably a good proxy for Germany’s contribution to the value of the Euro. In short, it shows that the dollar is on a secular trend towards lower values, and that the weaker members of the Euro are likely causing the Euro to remain cheap vs the Swiss Franc. My take-away from looking at these three graphs is that the Euro’s future trend is likely to be diluted by the weaker members of the EU, while the dollar continues on a trend towards cheapening versus the stronger components of the Euro.


On a more immediate perspective, the Euro’s rise from 1.18 to 1.28, only captures about 25% of the Euro’s recent fall from its 1.51 top last December. Long time readers of this blog will know that I typically expect major market retracements to fall between 38 and 62%, which are the two primary Fibonacci ratios. By this metric, the Euro could improve to 1.31 to 1.38, from 1.28 today. And this can all occur within the context of a declining Euro.


Meanwhile, the consequences of the Greek debt crisis have yet to play itself out. Behind the scenes, there is talk of proposals that the European Stabilization Fund (ESF), which will supposedly be funded with $440 billion Euros, will not offer a blanket guarantee for all EU sovereign debt. Instead, it has been floated that the fund will guarantee 50% of the principal value of EU sovereign debt. This helps explain why Greek debt, which the ECB bought with gusto in late March, has been allowed to rise in yield, and fall in price:


                               2 yr Greece        10 yr Greece  


Yield during crisis              18.22%              12.43%  


Yield after ECB purchases         6.60%               7.27%   


Yields today                      9.67%              10.31%   


Despite Greece’s successful sale of $2 billion of 6 month T-bills at a yield of 4.6% earlier this week, their debt markets are still indicating that all is not well. The 100+ billion Euros Greece is getting from the IMF and the EU will allow Greece to cover their debt maturities for the next 2 years, but somehow, the market does not trust that the bailout money will be there to cover their maturities, otherwise, why would their 2 year debt yield almost 10%, and why would Moody’s and S&P rate this debt BB?


There was news story last week which suggested that the lawsuit to block Germany’s participation in the European stabilization fund was still pending, and if this suit manages to succeed, then it would blow the Euro out of the water. The main contention of the lawsuit is that the treaties which led to the creation of the EU and the EMU (European Monetary Unit, aka the Euro), specifically stated that bail-outs for members of the EU is not permitted. Initially, this suit was filed to prevent Germany from contributing money to Greece’s immediate bailout, and the court chose not to block the German government. However, the court said that they wanted to hear the case, and was not going to derail the Greek bailout without hearing the case through their normal process, which takes months. Nonetheless, this suit, to block Germany’s participation in the ESF is still out there, and if in fact the suit is up-held, then havoc will result, and the Euro will collapse.


I am not saying this is going to happen tomorrow, or at all, but something could occur over the course of the next few months. When it does, some folks will call this a black swan event, when in fact, it will be a predictable earthquake, which takes a long time to set up, and only minutes for the damage to get inflicted.


* Historian warns of sudden collapse of American ‘empire‘ – on average, I like to summarize articles which are worthy, and in rare situations, I will copy articles entirely (with attribution). Such is the case today with a re-cap of a presentation by Nail Ferguson, the Harvard professor and expert on money:


July 14, 2010 “Aspen Daily News” — Harvard professor and prolific author Niall Ferguson opened the 2010 Aspen Ideas Festival Monday with a stark warning about the increasing prospect of the American “empire” suddenly collapsing due to the country’s rising debt level.


“I think this is a problem that is going to go live really soon,” Ferguson said. “In that sense, I mean within the next two years. Because the whole thing, fiscally and other ways, is very near the edge of chaos. And we’ve seen already in Greece what happens when the bond market loses faith in your fiscal policy.”


Ferguson said empires – such as the former Soviet Union and the Roman empire – can collapse quite quickly and the tipping point is often when the cost of servicing an empire’s debt is larger than the cost of its defense budget.


“That has not been the case I think at any point in U.S. history,” Ferguson said. “It will be the case in the next five years.”


Ferguson was conscious of opening the Ideas Festival on such a stark note.


“Walter Isaacson, the leader of this great institution said, ‘Don’t be too dark!,’” Ferguson said.


The affable British scholar tried to keep it light. He used a stage whisper to tell the Aspen Institute audience, “I know you’re not comfortable with the word ‘empire,’ especially just after the Fourth of July, but you are the Redcoats now.”


He said the U.S. is now deeply in the red as a country because of a combination of the Great Recession, the resulting federal stimulus and financial bailout programs, two wars, the Bush tax cuts, and a growth in social entitlement programs.


And economic debt can lead to a sudden loss of military power and global respect, Ferguson said.


“By combating our crisis of private debt with an extraordinary expansion of public debt, we inevitably are going to reduce the resources available for national security in the years ahead,” Ferguson said. “Because as a debt grows, so the interest payments you have to make on it grow, even if interest rates stay low. And on current projections, the federal debt is going to be absorbing around 20 percent – a fifth of all the taxes you pay – within just a few years.


“The item of discretionary federal expenditure most likely to be squeezed is of course defense. And there are lots of historic precedents for that,” said Ferguson, who is the author of “Empire: The Rise and Demise of the British World Order and the Lessons for Global Power.”


Ferguson said the financial crisis that started in 2007 has “has accelerated a fundamental shift in the balance of power,” with the U.S. shedding power and Chinaabsorbing it.


“I’ve just come back from China – a two-week trip there – and the thing I heard most often was, ‘You can’t lecture us about the superiority of your system anymore. We don’t need to learn anything from you about financial institutions and forget about democracy. We see where it has got you.’”


David Gergen of CNN, who moderated the discussion, which also included billionaire Mortimer Zuckerman, asked Ferguson whether it made a difference if the U.S. declined as a world power.


“Having grown up in a declining empire, I do not recommend it,” Ferguson said. “It’s not a lot of fun, actually, decline. To be more serious, a world in which the United States is no longer predominate is not likely to be a better world, actually.”


In what he called his “light moment,” Ferguson said, “I think there is a way out for the United States. I don’t think its over. But it all hinges on whether you can re-energize the real mainsprings of American power. And those two things are technological innovation and entrepreneurship.


“Those are the things that made the United States the greatest economy in the world and the critical question is, ‘Are we going to get it right?’ Can we revive those things in such a way that in the end we grow our way out of this hole the way the United States grew its way out of the 1970s and of course out of the 1930s?” By Brent Gardner-Smith (end of article)


To this I will add that the way in which Obama is pushing the US towards his brand of socialism is not going to jump-start the US economy and relieve the US of its unemployment burden. Instead, the shift in the legal, tax and economic environment, which these changes entail is just going to freeze business expansion and keep America from being what made us great.


* Yen Update – I am attaching a graph of the Japanese Yen, the one non-dollar currency I continue to like. The next graph on the attached shows the progress the Yen continues to make towards higher valuations. As the # of Yen you receive for a dollar drops, the value of each Yen rises. I expect this trend to continue. Here is a synopsis of the reasons why I like the Yen:


1> The yen is on a secular trend towards higher valuation, which dates back to the 1970s, when 1 dollar bought over 300 yen, see the next graph. The trend which went side-ways from 1995 to 2006, has resumed as the 11 year contracting triangle (in yellow) has ended. Resolution of this triangle suggests the yen will go below 80 Yen/dollar, with an ideal target of 55 yen/dollar;


2> There is real deflation going on in Japan, so 1 yen tomorrow will buy you more goods than today. Relative to other currencies, which have yet to start deflating, the yen should appreciate over time relative to all other currencies;


3> The yen has the lowest interest rates of all developed countries, even lower than the dollar, and accordingly, there are many banks and hedge funds which have borrowed heavily in yen. At some point in time, (usually when there is financial stress), these folks will have to buy back the yen, they are short. This is confirmed that whenever there is financial stress, that the yen does better, and given that I do not think the next few years are going to be a cake-walk, then this suggests that the yen will continue to appreciate;


4> Everyone hates the Yen, especially because Japan’s cumulative deficit is twice its GDP, the largest in the developed world. However, and unlike the US, Japan funds its deficit with internal/domestic savings and can control its own destiny in that regard;


5> Japan has significant investments around the world, and continues to run trade surpluses. In fact, Japan owns over $700 billion of US treasuries, and can use that hoard to defend its currency as needed. All this is bullish for the yen.


In short, I still like the yen, despite the fact that everyone hates it. I own yen in 0% yielding bank accounts because I do not want to buy 10 year government debtat a yield just above 1%.