Older readers may remember an old British music hall song titled "The Man Who Broke the Bank at Monte Carlo". Well now we have the man who may have broken the Bank of Europe. He is Jean Claude Trichet, the outgoing president of the European Central Bank (ECB) who steps down on Oct. 31.
What did he do to warrant such a serious accusation? He presided over two quarter-point increases in short-term euro interest rates between April and June, moving from 1% to 1.5%. In the process, he managed to tighten monetary conditions at a time when the European banking industry was already contracting its balance sheet.
As I noted in the article I wrote on Europe a couple of months ago, the problem for European banks has been the large amount of government debt that they own which was issued by peripheral eurozone countries such as Greece, Ireland, and Portugal. This debt was priced at 100% of face value during the two stress tests carried out by authorities in 2010 and earlier this year.
Of course, by the time the second stress test was undertaken in April, Greek two-year debt was already trading at €79 per €100 of face value and 10-year debt at €62. Now Greek, Portuguese, and Irish long-term debt is trading at prices of less than €50 if bids can be obtained. More importantly, the malaise has spread to Spanish and Italian debt, which saw yields on 10-year debt exceed 6% a few days ago. That was a record margin above German 10-year Bunds since the creation of the eurozone in 1999.
The announcement that the authorities were buying Spanish and Italian government bonds through the €440 billion European Financial Stabilization Facility (EFSF) last week saw yields rapidly dropping back to under 5%, but this has only temporarily relieved the crisis.
The reality is that the EFSF is too small to do more than buy time for the European authorities. It will be exhausted before the end of this year if it continues to buy Spanish and Italian debt at the same rate as the last couple of weeks. Theoretically, purchases of debt issued by these countries needs to be approved by the parliaments of all 17 eurozone members. But numerous observers have noted this will not be possible before they return from their vacations in early September, so the EFSF has already been forced to exceed its official terms of reference.
More importantly, the lack of firm decisions at the emergency summit between French president Nicholas Sarkozy and German Chancellor Angela Merkel (the not-so-dynamic duo were nicknamed Merkozy) on Aug. 16 saw a dramatic sell-off in European stocks. The FTSE Eurofirst 300 Index fell 6.3% for the week and European banks were decimated. The largest German bank, Deutsche Bank, was down 10.2% last week. The second and third largest French banks, BNP Paribas and Societe Generale, were off 12% and 14% respectively and Italy`s largest bank, Unicredit, saw its shares fall almost 15%. This was despite the introduction of a ban on the short selling of financial stocks by France, Italy, and Belgium the week before.
In an a article this weekend entitled "Ominous Portents for European Banks", London's Financial Times noted that the spread for credit default swaps (CDS) for European banks - essentially the price to ensure against default for five-year bonds - had hit the highest level ever for large French and Italian banks as well as for Spain`s largest bank, Banco Santander. Three-month interbank lending rates for euros are at their highest levels since 2009 and Italian use of the ECB funding facilities doubled in July to €80 billion, the highest in at least four years.
All Merkozy could come up with was the discredited suggestion of a tax on financial transactions and more austerity measures for the PIIGS, when it is apparent that what these economies desperately need is higher growth. By failing to agree that the monetary union of the eurozone had to be backed by an effective fiscal union, with similar taxation and labour market policies in all countries, Sarkozy and Merkel exposed the fault lines in the euro project.
Having a single currency for 17 countries with different economies and fiscal policies makes economic problems impossible to resolve while retaining the straitjacket of a single currency. The only solution is to allow countries to leave the eurozone and devalue, unless the strongest country in the currency zone (Germany) is prepared to fund the profligate policies of the weaker countries such as the PIIGS (Portugal, Ireland, Italy, Greece, and Spain). Not surprisingly, German voters seem unenthusiastic about this prospect. Reflecting that view, Chancellor Merkel not only declined to endorse fiscal union at the summit but this week she declared that issuing eurozone bonds is not "a possibility". In other words, Germany, with its memories of hyper inflation in the 1920 Weimar Republic and in post-war occupied Germany, seems unwilling to let the ECB print enough euros to inflate away the debt burden of the PIIGS and recapitalize the European banks.
In this context, Mr. Trichet`s actions in raising interest rates earlier this year to counteract commodity-driven inflation pressures are very reminiscent of his previous error in 2008. Then he was also raising interest rates even after Bear Stearns had to be rescued in March 2008, while other central banks were reducing theirs. He finally reversed himself after Lehman Brothers collapsed in September.
By tightening conditions unnecessarily and reducing the steepness of the yield curve between short-term interest rates and longer-term bond yields last spring, the ECB made European banks less profitable and less able to write off their bad credit exposures. Furthermore, while in the U.S., the U.K., and Canada government bonds remain obligations that will be repaid at par in the same currency, it was already evident by spring of this year that there was credit risk in sovereign debt issued by peripheral eurozone governments.
The error has now been reinforced by the unwillingness of the European political class to admit the euro project is fatally flawed and allow the weaker members to depart and devalue their way to higher growth, as the U.K. and Italy did when they left the ERM (the euro's predecessor) in 1992. The only other alternative is to agree to full fiscal union and issue eurozone bonds backed by the entire euro area, effectively allowing the PIIGS credit risk to be assumed by Germany.
For Canadian investors, I reiterate my advice from my last column. Avoid eurozone banks, mutual funds that have large exposures to them, and companies dependent upon domestic European demand. Growth in the eurozone area fell to 0.3% in the second quarter, down from 0.8% in the first quarter. Germany`s GDP growth in the second quarter plummeted to 0.1%. As Gordon has noted, there are some attractive European stocks but they tend to be multi-nationals with exposure to the fast-growing emerging markets, that will benefit from a weaker currency. The euro will end up weakening sharply, especially when euro interest rates come back down later this year.
The fact the U.S. dollar actually weakened against the euro last week, as record inflows into U.S. Treasuries drove yields on the 10-year bonds down to less than 2% (a 60-year low) shows just how concerned investors are about the U.S. dollar as well. From a Canadian dollar perspective neither currency is attractive and exposures should be hedged.
In practical terms, this means that whenever you have the option of choosing a currency-hedged mutual fund or ETF, you should take it. Currency movements could be very volatile in the coming months and you need to shelter your investments against this to the extent possible.