four reasons why the euro is not crashing

7/30/2019 Four Reasons Why the Euro is Not Crashing

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Four Reasons Why The Euro Is NotCrashing

Submitted by Tyler Durden on 05/21/2012 13:23 -0400

Based on a swap-spread-based model, EURUSD shouldtrade around 1.30, but based on GDP-weightedsovereign credit risk EURUSD should trade around1.00; so who is right and what are the factors thatsupporting the Euro at higher levels than many would

assume (given the rising probability of a Euro-zone #fail and the 0.82 lows from 2000). UBSaddresses four key reasons for the apparent paradoxbased on the difference between ECB and Fed'monetization', the EZ's balanced current account(independent of foreign capital flows), and the high-oil-price induced petro-dollar circulation diversifying intoEuros (or out of USD). The final and most telling of factorsthough is bank deleveraging as European financialentities, who remain under pressure to shrink theirbalance sheets and re-build capital, have beenselling foreign assets. They remain EUR dismalists witha year-end target of 1.15 but expect the slide to theselevels to be cushioned (absent an imminent break-up) bybanks' 'shrinkage'.

Based on a pure swap-spread model, it appears EURUSDis starting to price in liquiidty risk once again (as it did last

year - green ovals)...
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But the pressure remains on EURUSD via the massive risein credit risk across the Union's members (with parityseemingly attractive)...

and so from UBS - EURO - Who's Buying?Financial markets are starting to price in the risks that theEurozone may split apart following this month'sinconclusive elections in Greece. But the euro, whiletrading back to this year's lows against the dollar at 1.27-1.28, remains far above its lifetime lows of 0.82 recordedin 2000.

What explains this paradox?
http://www.zerohedge.com/sites/default/files/images/user3303/imageroot/2012/05-2/20120521_Euro2.pnghttp://www.zerohedge.com/sites/default/files/images/user3303/imageroot/2012/05-2/20120521_Euro1.png


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First, the European Central Bank so far has notengaged in outright quantitative easing during thefinancial crisis. Moreover, while the Federal Reserve, theBank of Japan and the Bank of England all have cut

interest rates to between zero and 0.5%, the ECB'sbenchmark interest rate remains at 1.0%. In contrast,investors are concerned the Federal Reserve will engagein a third round of quantitative easing. Similarly, the Bankof Japan and the Bank of England have also been printingmoney and buying government bonds.

Second, the Eurozone as a whole runs a balancedcurrent account. Thus it is not dependent on foreigncapital inflows to support the value of the euro.

Third, high oil prices have increased the petro-dollarsaccumulated by central banks and sovereignwealth funds in the Middle East, North Africa,

Commonwealth of Independent States and Norway.These official investors diversify a portion of theirnew foreign reserves into Eurozone markets.

And, last, Eurozone banks under pressure to shrinktheir balance sheets and rebuild capital have been

selling foreign assets.


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As Chart 1 shows the ratio of loans-to-deposits peaked inthe Eurozone close to 125% in 2007 when the creditcrunch began. Since then the ratio has declined to 115%but largely because of an increase in deposits. AsEurozone banks further reduce the size of their balancesheets, they are likely to cut loans now including thosefrom abroad. That leads to repatriation flows supportingthe euro.

How long can such deleveraging go on?
http://www.zerohedge.com/sites/default/files/images/user3303/imageroot/2012/05-2/20120521_Euro3.png


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Chart 2 shows how the ratio of loans-to-deposit has fallen

from its peak in Japan in 1992, the US in 2008 and the UKin 2007. For the last two decades Japanese banks havesteadily reduced their loans-to-deposits ratio from 130%in the early 1990s to below 80% now.

American and British banks have also been deleveragingsharply over the last few years. But Eurozone banks have

been much slower, suggesting they will spend many moreyears slimming down their balance sheets now. Thatshould lead to more repatriation flows to the benefit ofthe euro.

Thus while the euro is set to keep sliding owing tothe debt crisis in the Eurozone - our end year targetis 1.15 against the dollar - in the absence of a breakup of the single currency area, the euro's decline

should be cushioned by the Eurozone's banks.
http://www.zerohedge.com/sites/default/files/images/user3303/imageroot/2012/05-2/20120521_Euro4.png


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four reasons why the euro is not crashing

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