September 9, 2011
Given that many know Merk Investments as "euro bulls", arguing that the euro can thrive despite all the turmoil in the Eurozone, we wanted to share with our investors and the public that in our hard currency strategy, currently with over $700 million in assets, we sold over U.S. $90 million worth of euros late Thursday to re-allocate to the Australian dollar. This re-allocation was an acceleration of a recent trend to deploy euro holdings elsewhere. The strategy is now underweight in euros.
Our move was motivated by recent European Central Bank (ECB) and U.S. Federal Reserve communication:
- A more dovish tone by ECB President Trichet leads us to believe the ECB may err on the side of easing earlier than previously anticipated; the ECB raised interest rates twice earlier this year. A rate cut may take place in the Eurozone as early as next month so that Trichet's successor Mario Draghi, who will succeed Trichet this November, won’t have to initiate interest rate reductions as his first move. These dynamics may negatively affect the euro until clarity is provided. Draghi may feel pressure to keep rates high, given that he likely needs to prove his credentials as a “hawk”, especially given the pervasive skepticism that an Italian central banker could possibly take a hawkish stance.
- In the U.S., the Federal Reserve (Fed) President Ben Bernanke appears eager to engage in another round of quantitative easing of some form (QE3). Keep in mind that the liquidity injected through QE2 remains available to the banking system in the form of excess reserves; also keep in mind that the Federal Open Market Committee (FOMC) crushed short-term interest rates when it recently committed to keeping interest rates low until at least the middle of 2013. Even if one thought that these policies were prudent (which we don’t), a cautious central bank would typically wait to see the impact of these actions. Instead, Bernanke is raising market expectations of further monetary easing. In our assessment, a key beneficiary of such a move would be the Australian dollar. The rationale here is that policy makers continue to fight market forces in the U.S., as consumers in particular would rather downsize than borrow more; in such an environment, we have argued that money may flow to where there is the greatest monetary sensitivity for such a move; aside from commodities and precious metals, commodity currencies such as the Australian dollar may benefit.
While we are underweight the euro in the short-term, we remain long-term positive, as we believe the concerns surrounding the crisis in the Eurozone should primarily be played out in the pricing of the bond market: in our assessment, it is appropriate to have the bonds of Eurozone countries trade akin to municipal bonds, as they cannot print their own money. As such, the bond market has been providing “encouragement” for reform. The process, granted an ugly one, is imposing structural reform; as countries drag their feet implementing reforms, the bond market will continue to keep policy makers’ feet to the fire. The same can be said of banks: courtesy of recent stress tests, the market can now target weak banks, “encouraging” them to raise more capital. Also note that while a centralized European fiscal authority would be helpful, we already have a mechanism in place in which a country that wants to tap into cheaper funding has to give up sovereign control over its budgeting. The difference is that a streamlined process under which a country could tap into Eurobonds would be less stressful than the drama playing out whenever someone needs to access the International Monetary Fund (IMF) and European support resources. Germany is right in resisting a rush to introduce Eurobonds, so that processes are put in place that don’t lead to excessive money squandering. Overall, we believe it is far more difficult in the
Eurozone to spend and print money than in the U.S.
As such, we are fighting the myth that economic growth is necessary to have a strong currency. We believe that this relationship is true in countries with a current account deficit, notably the U.S.; but at the other end of the spectrum, Japan, we have seen decades of lackluster growth, yet a strong currency. Indeed, a government incapable of introducing spending programs allows market forces to play out, leading consumers to spend less and save more: given that Japan historically finances its deficits domestically, a slowing economy may be a positive for the yen. The Eurozone, with a current account roughly in balance, may experience a strong euro even with the turmoil going on. Think of it this way: in the U.S., Fed Chairman Bernanke has testified that going off the gold standard during the Great Depression may have helped the U.S. recover faster than those that held on to the gold standard. What many don’t fully appreciate is that someone is on the other side of the trade. In today’s world, we believe the euro is on the other side of Bernanke’s trade: as the ECB has only printed a fraction of the money the Fed has printed, the Eurozone economy may exhibit lackluster growth, but the currency may ultimately be much stronger.
Having said that, we must not ignore other factors in this analysis, such as the more dovish view of the ECB in the short-term. Long-term, we would like to point out that commodity prices may remain elevated for a long time as a result of continued easy central bank money; the Fed historically considers high commodity prices transitory, whereas central banks in the rest of the world typically tighten monetary policy in an effort to minimize what is referred to as “second round effects”, i.e. the creeping of inflationary pressures through the value chain. For this reason alone, diverging monetary policies may be evident for a considerable period; Fed policy may stay on the side of easing, whereas ECB policy may have a tightening bias.
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