Three More Reasons Why The Euro Rally Should Continue

``Inflation is not the result of a curse or a tragic fate but of a frivolous or perhaps even criminal policy.” -Ludwig Wilhelm Erhard

Lady Luck seems to smile at us, given that our forecasts of last week appear to have been serendipitously realized. The Euro surged by 2.4% over the week and risk assets turned materially positive, exactly as we spelled out[1].

But of course, we hardly ever talk about ONE week, we allude to near to medium term which may cover the outcome for the rest of the year. Perhaps the Euro may recover to the 1.30 to 1.32 level by the yearend?

There are three more reasons why the Euro should persist to rally and why risk asset markets are likely to gain momentum.

First of all, emerging markets continue to lead the way in terms of economic growth[2], whereby EM economies may do some heavy weightlifting to buttress developed economies.

And the cyclical broad based EM led global economic recovery, as a result of the expansive monetary policies and from globalization friendly policies, will likely expand global trade.

By cyclical recovery we allude to the bubble cycle.

Yet considering what mainstream calls as ‘global imbalances’, seen in many ways as ‘savings glut’, ‘dearth of investments’ or ‘Bretton Woods II’, instead we see this in terms of the Triffin Dilemma, where an international reserve currency, particularly the US dollar, would need to run large deficits in order to finance this burgeoning global trade from the cyclical recovery.

The Triffin Dilemma, according to Wikipedia[3], ``was first identified by Belgian-American economist Robert Triffin in the 1960s, who pointed out that the country issuing the global reserve currency must be willing to run large trade deficits in order to supply the world with enough of its currency, to fulfill world demand for foreign exchange reserves.”

``The use of a national currency as global reserve currency leads to a tension between national monetary policy and global monetary policy. This is reflected in fundamental imbalances in the balance of payments, specifically the current account: to maintain all desired goals, dollars must both overall flow out of the United States, but dollars must at the same time flow in to the United States. Currency inflows and outflows of equal magnitudes cannot both happen at once.”

This is one explanation mainstream can’t accept because it puts into the light or magnifies the inherent flaws of the current monetary standard, which the theory projects as unsustainable. Of course, homemade or national policies exacerbate such conditions.

But the point is, mainstream sees that the de facto currency reserve standard as an entitlement that must never be compromised, hence espouse theories even where water, in its natural state, can move upstream.

For instance, some see monetary policies will be engineered to promote exports.

Figure 7 BCA Research: Bearish On US Dollar

According to BCA Research[4], ``The U.S. also needs strong exports and an improving trade balance to add to GDP growth. Last week’s news on the U.S. trade front was not encouraging, with the deficit widening again in April. Furthermore, cyclical and structural factors are pointing to even wider trade and current account deficits ahead. In turn, with the unemployment rate still near 10%, U.S. policymakers are also unlikely to tolerate significant strength in the dollar and the consequent drag on growth.”

This outlook sees the application of monetary policies as a ‘one way street’ or where the policy actions of the other pair (or the other nation which is represented by the opposite currency) may not offset those of the US. This is pretty much one sided because monetary policies are not only relatively dynamic but also has relative impacts from perpetually evolving policy actions.

Secondly, the implication is that export growth can only be achieved by devaluation. Hence the kernel of this mercantilist leaning view is that every nation will try to out-export each other by competitive devaluation, or the race to devalue via inflationism which presumptively leads to prosperity.

Yet this outlook could lead to fatal results, as Ludwig von Mises warned[5], (bold emphasis added)

``they depend on the condition that only one country devalues while the other countries abstain from devaluing their own currencies. If the other countries devalue in the same proportion, no changes in foreign trade appear. If they devalue to a greater extent, all these transitory blessings, whatever they may be, favor them exclusively. A general acceptance of the principles of the flexible standard must therefore result in a race between the nations to outbid one another. At the end of this competition is the complete destruction of all nations' monetary systems.”

In other words, nations don’t trade people do. Yet people don’t trade to generate economic growth, people trade to have a need fulfilled and or to obtain profits. Nations only account for the cumulative actions of individuals. Hence inflationism isn’t an optimum way to meet such goals.

Besides, merchandise trade (exports and imports) for the US is only about one-fourth of the economy, such that the call to devalue in order to support the export industry, which is only 12% of the economy at the expense of the 88%, would seem absurd. Moreover, US unemployment from the 2008 crisis has been less related to the export industry as most of the job losses has emanated from the bubble areas (e.g. mortgage, construction etc...).

For me, the Triffin Dilemma has played the biggest role in shaping the underlying trend of the US dollar. And a global recovery translates to a weaker US dollar.

Next, the credit risks seem tilted towards US states than from the Eurozone economies (see figure 8)

Figure 8: The Economist: American states' finances are worse than those of some euro zone countries

According to the Economist[6], (bold emphasis mine)

``RECENT comparisons made between some American states' finances and those of Greece are exaggerated. But credit-default-swap (CDS) spreads, which measure investors’ expectations of default, are wider for some American states than for some of the euro zone’s other peripheral economies. On June 17th the cost of insuring Illinois’ bonds against default hit a record high, rising above that of California, America’s largest municipal borrower. Both considered riskier than Portugal’s debt. New York and Michigan are higher than Ireland’s. Like euro-zone members, American states may not declare bankruptcy and cannot be sued by creditors. And like many European governments, legislators are reluctant to impose the pain necessary to close budget deficits.”

As we pointed out last week, the downtrodden state of the Euro has emanated mostly from overly depressed sentiment. This has constrained demand for the Euro and has been more than the problem of relative structural issues, which seem to lean against the US. Thus, when finical sentiment shifts, structural issues will come into play.

Importantly as the Economist explains, fiscal discipline may not be stringently observed by both the affected parties in the Eurozone and in the US states. That’s because this may not be politically palatable for politicians. This serves as euphemism more inflationism.

Lastly, if the Euro is soon destined towards disintegration, as alleged by some, then she is probably looking towards the inclusion of more nations to join her death leap.

That’s because the Eurozone has enlisted Estonia as her newest member. Estonia will be the 17th country to carry the Euro by January 1, 2011.

Earlier we dealt with Estonia’s free market leaning approach even towards dealing with the recent crisis[7]. And perhaps such accomplishment has been recognized by the Euro bureaucracy.

According to the New York Times[8], ``Meeting in Brussels, Europe’s 27 governments hailed the “sound economic and financial policies” that had been achieved by Estonia in recent years. They said Estonia would shift from the kroon to the euro on Jan. 1, 2011.”

And unlike Greece who fudged their data to foist herself into the EU membership, Estonia seems more qualified.

Or perhaps could it be that Euro officials have been desperately looking for an agitprop to buttress their position? This from the same New York Times articles[9],

“The door to euro membership is not closed because we are going through a sovereign debt crisis,” said Amadeu Altafaj, a spokesman for Olli Rehn, Europe’s commissioner for economic and monetary affairs. “Estonia’s admission is a sign to other countries that our aim is to continue enlarging economic and monetary union through the euro.”

“Continue enlarging economic and monetary union through the euro” even when the Euro is in the death throes? Hmmm.

In my view, these three factors, specifically, growing global trade which should expand US trade deficits and amplify the effects of the Triffin dilemma, the credit risks slanted towards US states more than the EU and Estonia’s as the Euro’s newest member should all add up to boost the Euro vis-a-vis the US dollar.

Of course, a better bet in place of the Euro should be Asian currencies, including the Philippine Peso.

---

[1] See Buy The Peso And The Phisix On Prospects Of A Euro Rally

[2] See Another Reason Not To Bet On A 2010 'Double Dip Recession’

[3] Wikipedia.org, Triffin Dilemma

[4] BCA Research Currencies: Still Broad U.S. Dollar Bears

[5] Mises, Ludwig von The Objectives of Currency Devaluation, Human Action, Chapter 31 Section 4

[6] The Economist, Risky business, June 18, 2010

[7] See Estonia’s Free Market Model And The US 1920-1921 Depression

[8] New York Times, What Crisis? The Euro Zone Adds Estonia, June 17, 2010

[9] Ibid

Parenting To Be Remembered

The conventional view of parenting is that parents shape their children's lives. But this perception is misguided.

Professor Bryan Caplan argues why, (Wall Street Journal) [bold emphasis mine]

``Parents may feel like their pressure, encouragement, money and time are all that stands between their kids and failure. But decades' worth of twin and adoption research says the opposite: Parents have a lot more room to safely maneuver than they realize, because the long-run effects of parenting on children's outcomes are much smaller than they look.

``Think about everything parents want for their children. The traits most parents hope for show family resemblance: If you're healthy, smart, happy, educated, rich, righteous or appreciative, the same tends to be true for your parents, siblings and children. Of course, it's difficult to tell nature from nurture. To disentangle the two, researchers known as behavioral geneticists have focused on two kinds of families: those with twins, and those that adopt. If identical twins show a stronger resemblance than fraternal twins, the reason is probably nature. If adoptees show any resemblance to the families that raised them, the reason is probably nurture.

``Parents try to instill healthy habits that last a lifetime. But the two best behavioral genetic studies of life expectancy—one of 6,000 Danish twins born between 1870 and 1900, the other of 9,000 Swedish twins born between 1886 and 1925—found zero effect of upbringing. Twin studies of height, weight and even teeth reach similar conclusions. This doesn't mean that diet, exercise and tooth-brushing don't matter—just that parental pressure to eat right, exercise and brush your teeth after meals fails to win children's hearts and minds.

``Parents also strive to turn their children into smart and happy adults, but behavioral geneticists find little or no evidence that their effort pays off. In research including hundreds of twins who were raised apart, identical twins turn out to be much more alike in intelligence and happiness than fraternal twins, but twins raised together are barely more alike than twins raised apart. In fact, pioneering research by University of Minnesota psychologist David Lykken found that twins raised apart were more alike in happiness than twins raised together. Maybe it's just a fluke, but it suggests that growing up together inspires people to differentiate themselves; if he's the happy one, I'll be the malcontent.

``Parents use many tactics to influence their kids' schooling and future income. Some we admire: reading to kids, helping them with homework, praising hard work. Others we resent: fancy tutors, legacy admissions, nepotism. According to the research, however, these tactics barely work. Dartmouth economist Bruce Sacerdote studied about 1,200 families that adopted disadvantaged Korean children. The families spanned a broad range; they only needed incomes 25% above the poverty level to be eligible to adopt. Nevertheless, family income and neighborhood income had zero effect on adoptees' ultimate success in school and work."

This doesn't suggest that parents should leave or abandon their children to their own fate. Instead parents should just relax and take life in stride.

Professor Caplan writes,

`` Watching television, playing sports, eating vegetables, living in the right neighborhood: Your choices have little effect on your kids' development, so it's OK to relax. In fact, relaxing is better for the whole family."

This also means that parents should relieve themselves of what one might call self-imposed pressures of forcing their children to live a life designed according to their ideals, because the ultimate goal, is according to Professor Caplan, to be remembered, " The most meaningful fruit of parenting, however, is simply appreciation—the way your children perceive and remember you."

Happy Father's Day!

Another Reason Not To Bet On A 2010 'Double Dip Recession'

Here another reason why it does not seem worthwhile to bet on a double dip recession.

This from the Wall Street Journal Blog, (bold highlights mine)

``This year is likely to be among the last in which developed economies account for the largest share of global economic output, according to a report published Wednesday by the Organization for Economic Cooperation and Development.

``The Paris-based think tank said that in 2010, its 31 developed-country members will account for 51% of world economic output. But with the rapid growth of China, India and other developing economies, that share has narrowed from 60% in 2000 and the OECD predicts it will shrink further to 43% by 2030.

“The world’s center of gravity has moved towards the east and south,” the OECD said. “This realignment of the world economy is not a transitory phenomenon, but represents a structural change of historical significance.”

The OECD said that as a result of the entry of China, India, the former Soviet Union and others into the global market economy from the early 1990s, the number of nations converging with the wealth levels of developed economies has risen to 65 from 12.

The OECD defines a converging economy as one in which growth in output per person is double that of developed economies.

Another consequence of the shift in global economic growth is the sharp fall in the number of countries defined as poor, to 25 from 55.

The OECD said that while the initial spur to growth in developing economies came from their move away from central planning and state ownership, two additional factors have contributed to the shift in economic power.

The rapid expansion of China, India and other large developing economies boosted demand for many commodities, to the benefit of producers in Africa, Latin America and the Middle East.

And many converging economies became net creditors rather than net debtors, keeping U.S. and global interest rates low.

Some comments

-Clearly the 'converging economy' dynamic is mainly a function of globalization. Voluntary exchange or free trade isn't a zero sum game as mistakenly thought by the mainstream. That because the benefits are broad based or dispersed.

To quote Murray N. Rothbard,

``The process of exchange enables man to ascend from primitive isolation to civilization: it enormously widens his opportunities and the market for his wares; it enables him to invest in machines and other “high-order capital goods”; it forms a pattern of exchanges—the free market—which enables him to calculate economically the benefits and the costs of highly complex methods and aggregates of production."

-second, the additional two factors mentioned, particularly the expanded use of commodities and a shift to net creditor status, are consequences of and not causal variables to the converging economies. As cited above, wider trade enables for added investments (higher commodity demand) and capital accumulation (net creditors).

-lastly, given the backdrop of increasing globalization, there are many additional variables that contribute to the complexity of markets and economies. Bottom line: the narrow focus on one or two issues may prove to be inadequate in making a cogent analysis.

What The Distribution Of S&P 500 Sector Weightings Seem To Say

Bespoke has a nice depiction in the distribution of weightings among different sectors constituting the US S&P 500.

Bespoke writes,

``Technology is currently the biggest sector in the index at 18.9%, and it has been the biggest since it overtook the Financial sector early on in the financial crisis. There has been quite a bit of movement in sector weightings in recent years. At the bear market low in March 2009, the Financial sector made up just 8.9% of the index. It has charged back since then and has nearly doubled its weighting to 16.3%. Consumer Discretionary, Industrials, and Technology are the only other sectors that have increased their weightings during the current bull market. Health Care has really dropped off, going from 16.1% at the bear market low to its current level of 11.8%. Energy has also dropped quite a bit from 14.3% to 11%. There are now five sectors with weightings that are between 10.5% and 11.8%. Utilities, Materials, and Telecom continue to have very low weightings, and combined they still make up less than the 7th largest sector. The performance of any of these three sectors has a very minimal impact on the overall direction of the market." (bold emphasis added)

Some observations:

-The steady growth of the technology sector, and its apparent leadership today appears to reflect on the fast evolving US economy into the information age.

-The recent upsurge of the financial exhibits massive inflationism

-who says the US consumer is dead? Consumer discretionary outperformed the others, second only to financials based on the changes on March 2009 and the current

-the growth of in the industrials also suggest that the US economy is seeing some 'progress'

-at the current circumstance, there is a tight competition in 5 sectors: health care, consumer staples, energy, consumer discretionary and industrials, where I think energy has been underappreciated.

Thought Of The Day: The Fallacy of Deficit Spending

Here is Andrew Coyne on deficit spending:

``And even if you thought deficit spending was the answer to a problem of insufficient aggregate demand, it was hard to see what relevance it had to the credit crisis, which was primarily a problem of supply. As the economist John Cochrane, of the University of Chicago, has written, imagine if several major oil refineries blew up at the same time, leaving gasoline in short supply: “Stimulating people to drive around would not revive gas sales.” All it would do is drive up gas prices. Substitute banks for refineries, and the point becomes clear.

(bold highlights mine)

Has Slowing Philippine Exports Been Indicative Of Asia's Trend?

Rebecca Wilder of News N Economics exhibits concern over the slowing growth in Philippine exports as portentous of a slowdown for Asia.

She writes, (bold highlights mine)

``But the Chinese release overshadowed the Philippines April trade report, which in my view, illustrates more transparently the slowdown in external demand that is likely underway across the region. In the Philippines merchandise exports increased 27.4% over the year in April, which was half the rate of the Bloomberg consensus and that in March, 42.7% and 43.8%, respectively.

``A negative export growth trend has been established - explicitly in the Philippines and likely going forward in China (see Goldman Sachs report below). And these countries have strong trade ties with Europe - the Eurozone was 15% of 2009 world GDP (PPP value) according to the IMF.

``Therefore, recent nominal appreciation of the Philippine peso and Chinese yuan against the euro, and expected real appreciation - Europe's self-imposed economic contraction stemming from harsh fiscal austerity measures will drag prices downward - may very well hamper the economic recovery for key Asian economies via the export channel."

I see this dynamic from a distinct prism.

Looking at the broader picture, Philippine share of external trade has been slowing-- from 100% (2004) to about 60% (today) of GDP, according to the chart from Google/World Bank. Even China's external trade has been slowing.

Alternatively this means economic growth is becoming more domestic oriented.

Yet, this comes in the backdrop of an ascension of global trade.

Growing global trade amidst a slowdown in China's share suggest that the global share of the export pie is becoming more diffused, as more nations participate.

The implication: global economic growth isn't anchored on China, nor is it predicated on exports.

Moreover, there are many factors that drive economics more than just a simplistic currency-export-economic growth model.

The following is the export performance of the Philippines, China and the world (top window) as well as the Philippine Peso (bottom window).

What I want to show is that Philippine exports peaked in 2002-2004 even when the Peso continued to fall. The Peso reached a trough of 56.20+ to a US dollar in September of 2005. That's ONE year after. Yet Philippine exports haven't picked up.

So the Philippine case essentially invalidates the assumption that weak currency equals strong export growth.

And I think this applies also elsewhere, for the simple reason that export products and markets are not homogeneous, which implies diverse degree of price sensitivity. In the information age, we are increasingly witnessing niche (tribal) markets.

Let me further show that measuring Philippine exports is relative.

As the chart from NSO illustrates, it is a mirage to think that 40+% growth momentum will be sustainable. And falling off the high "growth" levels need not translate to alarm bells.

That's because in reality, markets don't move in a straight line.

Taking a look at the breakdown of products exported, they only show that the export growth has been "broad based" (from manufacturing to commodity)--premised on a year to year comparison. This further suggests that any slowdown may be temporary.

Therefore, interpretations of a pause as impending signs of doom seem unwarranted.

Looking from the Philippine perspective, this implies that if micro developments refutes the macro interpretation, then the latter is likely an inaccurate assessment.

Putting The TED Spread Into Perspective

Here is how to spook people...

TED spread are rising fast, so run for the hills!

Chart of the 6 month TED Spread courtesy of Bloomberg

The TED spread, according to wikipedia.org, is the difference between the interest rates on interbank loans and short-term U.S. government debt ("T-bills"). TED is an acronym formed from T-Bill and ED, the ticker symbol for the Eurodollar futures contract.

More from wikipedia.org

``Initially, the TED spread was the difference between the interest rates for three-month U.S. Treasuries contracts and the three-month Eurodollars contract as represented by the London Interbank Offered Rate (LIBOR). However, since the Chicago Mercantile Exchange dropped T-bill futures, the TED spread is now calculated as the difference between the three-month T-bill interest rate and three-month LIBOR...

``A rising TED spread often presages a downturn in the U.S. stock market, as it indicates that liquidity is being withdrawn."


Yet seen from a 5-year period, the perspective dramatically changes.

Thus, it has not been established yet whether the TED spread will reach a panic mode or hit extraordinary levels seen in 2008.

At present, rising TED spreads remain at pre-2008 Bear Sterns-Lehman levels (blue horizontal line) and have not encroached into panic territory.

Besides, there was much volatility during the pre-2008 as evidenced by the undulations. However, much of these gyrations had been muted until the unraveling of the concealed impairments seen in major US investment banks.

In addition, there are stark differences in 2008 and current conditions. For instance, then, policymakers dithered on how to intervene, today, they are quick to resolve any signs of volatility with a "shock and awe" 'throw money at the problem' approach. Example, today, Bank of Japan declared a new lending window to the tune of 3 trillion yen ($32.8 billion).

Importantly, the TED Spread isn't the only 'magical' indicator that determines conditions of the credit markets aside from the supposed spillover effects to the stock markets.

Therefore, I'd be leery of any analysis using the TED Spread to "spread gloom". That's because such insight seem to be misrepresenting the facts for a desired (biased) outlook. I call this "cart before the horse" reasoning.

Why 'Computer In Every Home' Won't Work

Because computer use is highly dependent on the individual.

This from the Wall Street Journal, (bold highlights mine)

``Giving laptop computers to students in fifth through eight grades to take home seems like an appealing idea. But economists Jacob Vigdor and Helen Ladd of Duke University’s Sanford School of Public Policy says it seems to reduce their scores on math and reading tests.

``The researchers looked at the questionnaires filled out by public school students in North Carolina — nearly 1 million of them between 2000 and 2005 — in which students report time spent on homework, time spent watching TV, time spent using home computers for homework as well as other data to gauge broadband access to their homes, which expanded substantially in those years.

“Students who gain access to a home computer between fifth and eighth grades tend to witness a persistent decline in reading and math tests,” they conclude. The effect is modest, they say, but statistically significant. Other studies, they say, are finding similarly discouraging results.

``One hypothesis: Broadband access crowds out time spent on homework. (You don’t need a Ph.D. to come up with this one.) “Internet service, and technology more broadly, is put to more productive use in households with more effective parental monitoring of child behavior.”

Bottom line: Individual incentives matter. Therefore, legal mandates to have computer in 'every home' risks a backfire: educational levels and productivity advancement could be jeopardized based on the dominant non-productive use of computers, and secondly, it's a waste of taxpayer money.

Buy The Peso And The Phisix On Prospects Of A Euro Rally

``The euro will survive, the shorties won't. A sound analysis of the fundamentals clearly shows that the euro's external position does not warrant its demise. The eurozone has no current account deficit and no net external debt and the global competitive position of many euro countries is strong. Even more so: the highly indebted "Club Med" countries along with Ireland have implemented the measures to get clean. This by itself is a global rarity.”-Antony P. Mueller, Euro Shorties Take Care

Coming from oversold levels, I believe that the Euro is ripe for a major bounce. And this should have a tremendous impact on global asset classes.

First of all let me point out that that I’m no fan of the Euro or for that matter any paper currency, including the Chinese Yuan or Philippine Peso. Like the fate of all previous paper currencies throughout man’s existence, they are all destined to meet their eventual doom.

That’s because the Fiat currency system functions as principal instruments of governments, through central banks, to advance on political goals of the political leadership which are mostly incompatible or clash with the universal economic laws.

As Friedrich Hayek wrote[1], (italics his)

What we should have learned is that monetary policy is much more likely to be a cause than a cure of depressions, because it is much easier, by giving in to the clamour for cheap money, to cause those misdirections of production that make a later reaction inevitable, than to assist the economy in extricating itself from the consequences of overdeveloping in particular directions. The past instability of the market economy is the consequence of the exclusion of the most important regulator of the market mechanism, money, from itself being regulated by the market process.

Hence most of the collapse of politically mangled currencies had been due to war or hyperinflation[2].

Reasons Why Euro Isn’t Going To Collapse, For Now

Having said so, this brings us to the next point; the allegations of the imminence of the death of the Euro, which in my view, seem highly exaggerated and representative of extreme pessimism.

Yes the Euro is bound to meet its inevitable demise, along with the US dollar and the others, somewhere down the road, but I don’t see it unravelling soon-not this year, or the next.

The fundamental reason is that interest rates globally remain at very low levels, from which allows governments to conduct inflationist rescue packages such as the recent nearly $1 trillion bailout of the Euro[3].

And low interest rates are emblematic of mitigated effects of inflation, for the time being.

Moreover, as we have earlier discussed, today’s globalization trends have NOT been restricted to trade, investment and financial, and labor flows, but such trend also incorporates monetary policies and government collaborative actions[4]. An example would be the recently reactivated currency swap arrangements and multilateral loans extended as part of the Euro rescue deal.

The point is, for as long as governments have the leeway to cross finance or accommodate each other, any talk of currency dissolution seems like wishful thinking.

In other words, what will immobilize governments from the present collaborative stance will be the series of dramatic interest rate responses to an accelerating rate of increases in inflation.

Under this scenario, the debt burdens of the financial system of those economies that are highly leveraged would be amplified and this effectively reduces the space for policy collaboration among governments and significantly lessens the accommodation for domestic government financing.

And it is under such juncture, where governments fighting their own domestic demons would forcibly either resort to the reglementary strictures of fiscal discipline (default or restructuring, a.k.a. partial default) or to hyperinflate. And the death knell or the survival of any currency will be determined by the accompanying critical policies made, when faced under such circumstances. Yes, we have long called this the Mises Moment.

International Uniformity Of Inflation

Yet if you read the many expert opinions, the above risks are simply ignored for the simple reasons of having too much blind faith on the efficaciousness of printing money, with less consideration of the unintended consequences from such actions, and too much reliance on short-term goals.

Figure 1: Danske Bank/BCA Research: ECB Quantitative Easing

For instance, one can find the excessive fixation to deflation by the mainstream as a pretext to advancing the cause of turning stones into bread by inflationism.

This from BCA Research[5],

``In our opinion, deflation is a much greater threat, especially if the central bank moves too slowly to limit contagion within the region. We sympathize with the concern that monetary policy in the euro area is set for the region as a whole and efforts to set interest rates to support the weakest members will over-stimulate the Germany economy. Unfortunately, relatively low trade-openness in the weaker nations means that currency depreciation will provide disproportionate support to the stronger regional members. As a result, the only way to stimulate the Med-4 successfully is to quantitative ease and ramp up asset purchases.”

Never mind the reality that the Eurozone isn’t being plagued by consumer price deflation in spite of the enormous debt problems because inflation has remained positive and has been climbing.

In May of 2010, according to news reports, Eurozone posted a positive 1.5% inflation rate[6]. While it is true that the Eurozone did experience a short bout of slight or marginal CPI deflation in June to October 2009, inflation has been more of the dominant story in this crisis.

Moreover, the deflation scare mongering is a matter of “data mining” or using selective statistics to rationalize a bias, such as in the right window of Figure 1.

The general idea is; since the European Central Bank’s (ECB) balance sheet have shown to be less engaged in activist policymaking via quantitative easing, the recommendation, hence, is to match the degree of aggressiveness employed by the US and UK.

This has been a fallacy predicated on having “uniform” inflationism, similar to the one exposed by Henry Hazlitt anent the Bretton Woods standard.

Mr. Hazlitt, who accurately predicted the collapse of Bretton Wood, warned[7], (all bold highlights mine)

``A provision for uniform inflation in all major countries would increase the temptation to inflate in each country by removing some immediate penalties. When the currency of a single country begins to sag because of inflationary policies, two embarrassing results follow. One is the immediate loss of gold, unless the Government prohibits its export (which makes the currency sag more); the other is the humiliation of seeing the country's currency quoted at a discount in other nations. A uniform inflation in the world's most important countries would avoid both of these embarrassments.”

And today’s near similar, coordinated and or convergent monetary policy actions seen in most nations and the policy collaboration among governments which have marked the current globalized environment seem to illustrate the same stance in the imposition of inflation on a “uniform” scale.

In addition, the metric commonly used to mount such a scare tactic has been monetary aggregates, which appears to have departed from the actions in the financial markets[8]. Plainly put, where statistics say deflation, real world prices say inflation.

Legendary investor Jim Rogers has a better refutation to this. In an interview, when asked about the effectiveness of monetary aggregates in measuring the risks of inflation or deflation, Mr Rogers replied[9], ``Is M3 something you buy in a shop? M3 can lead to changes in the price structure, but M3 is not price inflation or deflation.”

So it’s all a matter of choice, choose to live in the real world and see inflation or elect to live in a make-believe world which says deflation.

One mustn’t forget that the European integration had been longstanding pet project for European bureaucrats for over 50 years.

Whether the EU’s existence has been meant to achieve the following political goals:

-“Roman Empire” socialist democratic construct of modern Europe, instead of a liberal “Christian Europe”, as asserted by GaveKal’s Charles Gave[10] or

-in Stratfor’s Papic and Zeihan[11] view designed at projecting regional power in the geopolitical sphere where national power has been on a decline and or to reduce the odds of the repeated slant for warfare given the Eurozone’s geographical structures;

...it is important to stress that the European political ideology has been skewed to sustain the EU system at almost all conceivable costs.

Proof?

This from Bloomberg[12],

``European Union President Herman Van Rompuy said the 750 billion-euro ($905 billion) rescue package would be expanded if it doesn’t quell the debt crisis, becoming the first EU leader to float the idea of a larger fund.

``“Currently there isn’t even the hint of a request to put this rescue plan into practice,” Van Rompuy told Belgium’s Trends magazine. “And if the plan were to prove insufficient, my answer is simple: in this case, we’ll do more.”

And so the alleged barriers of the ECB’s purported independence from political influences is being gradually eroded or unravelled as a farce.

Betting On ‘This Time Is NOT Different’

THE weekly purchases by the ECB of financial assets meant to buoy the banking system appear to have slowed (figure 1 left window) as global financial markets appear to have calmed (see figure 2).

Figure 2: Danske Bank: Improving Sentiment

Aside from credit default swaps of the crisis affected PIIGS (right window), signs are showing of a marked broad based improvement in the money market metrics as exhibited by the LIBOR OIS [spread between the LIBOR and overnight swap rates-an indicator of banking health[13]] and FRA/OIS [the spread between future interbank rates and overnight indexed swaps] seen in the right window from Danske Bank Research[14]

The implication is, since there will likely be reduced anxieties over credit risk, we could probably see a resumption of recovery in the credit markets, considering the scope of actions being conducted by the monetary authorities in the EU area and elsewhere (Japan?), combined with continued fiscal spending by many global governments, aside from the steep yield curve which is likely to generate sundry borrow short-lend/invest long “carry” arbitrages.

None of these is meant to suggest that any impending recovery would be sound.

But we have always bear in mind that under a Fiat money standard, the reality is that boom-bust (Austrian Business) cycles have been repeatedly fuelled by the manipulation of interest rates which engenders malinvestments and distorts the production structure of the economy which subsequently leads to volatility from an ensuing market clearing process. And this cycle is further buttressed by moral hazard issues from government intervention even seen by neo-Keynesian Hyman Minsky.

Yet all these money printing and interest rate manipulations are likely to incentivize people to spend, speculate or search for added returns.

And I don’t think this cycle is going to be different. The only difference is likely to be the OBJECT or character of the bubble but not the dynamic that fuels the bubble.

Figure 3: stockcharts.com: Euro led meltdown

Yet when people or experts speak about “this time is different”, mostly represented as “new paradigm” during the electric atmosphere at the peak of a boom, or “death” of an asset in the depression phase, they usually signify as sentiment based or “comfort of the crowd” analysis.

In short, they can serve as manifestations of a major forthcoming inflection point.

So when we read about predictions of the ‘demise’ of the Euro over the next 5 years by a significant number[15] or 48% or 12 out of the 25 economists surveyed (!!), our contrarian reflexes suggests that a turning point for the Euro could be just around the corner.

To reminisce, last year they said that it could have been the death[16] of the US dollar[17], which apparently did NOT take place. On the contrary, the US dollar became one of today’s safehaven!

The lesson is once mainstream begins to sing in chorus on issues with questionable grounds, we tend to take the opposite stand.

Buy The Philippine Peso, Asian Currencies and The Phisix

In Figure 3 the falling Euro (XEU) began only to impact global markets by mid-April, via a convergence, where global stocks (DJW), commodities (CCI), emerging sovereign bonds (JEMDX) synchronically fell (blue vertical line and downward arrow in red).

Earlier, the falling Euro wasn’t much of a factor, as global markets had been indifferent (except commodities).

Yet the kernel of the apprehension seen in the financial markets came about when the Greece bailout was announced which apparently was construed as inadequate.

Now the tide seems to be turning (see blue vertical line guided by the green upside arrow).

It’s been the same dynamic with Asian currencies (see Figure 4).

Figure 4: Bloomberg-JP Morgan Asian Dollar Index[18]: Euro Convergence

The Euro’s decline hasn’t been a factor at the onset of 2010, where Asian currencies rose strongly against the US dollar, especially after the first round appearance of the Greece debt crisis episode last February.

However, the tremors following the “insufficient” Greece bailout turned nasty as Asian currencies fell concomitant with global financial markets.

But this trend appears to be likewise bottoming in conjunction with market activities in the commodities, bonds and stock markets.

Since the negative sentiment over credit risks appear to be abating, the current oversold Euro conditions, technical (chart) considerations, the massive pessimism over the Euro and the apparent bottoming of several asset classes, we are likely to see a significant rebound in Asian currencies as market sentiment improves.

For me, these factors should accrue to a strong buy on ex-US dollar currencies including the Philippine PESO, which last stood at 46.64 based on Friday’s close and other Asian currencies.

Naturally a rallying Peso should add to more levity in the Phisix.

Why? (see figure 5)

Figure 5: Philippine Peso and Net Foreign Trade

A rising Peso has mostly been accompanied by surges in foreign trade activities. This has been evident as the Peso reached its zenith (44.23) at the end of April to early May (see blue oval).

Lately as the Peso fell, it’s been mostly Net foreign outflows. This has been true for most of May until the second week of June, where in 6 weeks, only 2 accounted for inflows.

And as the Peso’s fall is likely to reverse, we could the same phenomenon take place.

Importantly, since foreign funds are likely to deal with Phisix issues, or the 30 component issues that comprise the Phisix benchmark, the prospective re-entry of foreign funds could translate to a big jump on the Phisix.

Although I’m not sure of the precise timing of the Euro reversal play, my suspicion is that it could happen over the coming weeks. But if I am lucky enough, it could even happen by next week.

There is another point I’d like to emphasize, if the relative valuation of a monetary unit is based ``on the relationship between the quantity of, and demand for, money[19]” then the lack of “inflationism” by the ECB relative to the US Federal Reserve and the Bank of England (go back to figure 1) should translate to the ‘quantity’ factor in favour of the Euro.

This leaves us with the demand for money, which is currently being driven by the mostly dour sentiment on the Euro. Therefore, the lack of demand has so far offset the quantity factor advantage. But this is likely to change once the turbulence over European credit markets breezes over.

Bottom line: There is likely to be a tremendous “leash effect” on global financial markets on a Euro rally vis-a-vis the US dollar. And if I am right, the Euro appears to be at an inflection phase of this market cycle.

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[1] Hayek, Friedrich August, Denationalisation Of Money p.102

[2] Dollardaze.org, Demonetized Currencies

[3] See $1 Trillion Monster Bailout For The Euro!

[4] See Why The Philippine Phisix Will Climb The Global Wall Of Worries

[5] BCA Research, ECB: Hesitation Is Lethal

[6] Associated Press, Eurozone official inflation edges up to 1.6% in May, May 31,2010

[7] Hazlitt, Henry From Bretton Woods To World Inflation, A Study Of Causes And Consequences p.40

[8] See M3 Not A Valid Measure Of Money

[9] Hera Research, Interview: Jim Rogers on Currencies and Inflation, goldseek.com, June 3, 2010

[10] See Was The Greece Bailout, A Bailout of The Euro System?

[11] See Inflationism And The Bailout Of Greece

[12] Bloomberg, EU to Expand Rescue If Package Fails, Van Rompuy Says, June 10, 2010

[13] Wikipedia,org LIBOR OIS Spread

[14] Danske Bank, Weekly Focus Another week in the shadow of the debt crisis

[15] Conway, Edmund, Euro 'will be dead in five years' Telegraph.co.uk, June 5, 2010

[16] Conway, Edmund Is this the death of the dollar? Telegraph.co.uk, June 20, 2009

[17] Fisk, Robert, The demise of the dollar, independent.co.uk, October 6, 2009

[18] Bloomberg Bloomberg-JP Morgan Asian Dollar Index (ADXY)

[19] Mises, Ludwig von Stabilization Of The Monetary Unit, On The Manipulation of Money And Credit, p.25