Well, so much for the supposed confidence-building announcements from the EU over the weekend. European equity markets fell heavily when trading resumed on Monday. Bond yields in Portugal, Spain, Belgium and even Italy continued to rise to new highs.
The bureaucrats in the EU are losing their already tenuous grip on the situation. Despite assurances that senior bondholders will not take ‘haircuts’ on their investments (not on lending before 2013 anyway) markets are imposing their own form of ruthless discipline.
For years the concept of risk was ignored. For years countries like Greece, Ireland and Portugal could borrow on terms almost identical to Germany, despite massive differences in economic structures.
Now, at a time when EU officials are desperately trying to convince markets that risk still doesn’t matter – that you can still have reward without risk – the markets are not buying it.
This puts mounting pressure on the European Central Bank (ECB) to ‘do something’. It meets on Thursday European time to discuss monetary policy. Bond investors will be sweating on the bank to open the liquidity floodgates and buy up peripheral European debt big time.
Whether it will do this is questionable. But even if it does, such action would only push the problem a few months down the track. We’re dealing with a problem of solvency here, not a liquidity problem. Such problems cannot be dealt with by temporarily monetising debt.
We wonder how Ben Bernanke is feeling about all this. On the one hand, he’s probably relived that some other central banker is the centre of attention for a change. On the other, he’s probably gutted that his QEII plans seem to have backfired.
Check out the chart of the US dollar index below
The dollar has rallied strongly since Bernanke announced his money printing scheme in early November. Things haven’t exactly gone according to plan for Ben. He’s trying to lower the value of the dollar to generate inflation and boost export competitiveness.
But he’s forgetting the minor point about the US dollar being the world’s reserve currency. In times of economic stability, the US dollar will generally trade according to domestic fundamentals. In times of turmoil though, it retains its safe haven status.
Because the euro is under all sorts of pressure, capital is now flowing back to the US dollar. It’s all relative in the world of currencies and as bad as the US dollar looks, it’s not as bad as all the other major currencies.
If there’s one lesson to be learned from the euro crisis it’s that problems begin at the core. The US dollar is at the epicentre of the global economy. The peripheral currencies (euro, yen) will likely come under major pressure before the greenback faces its day of reckoning.
But one thing is for sure, the dollar is not as good as gold. Gold is in a consolidation phase at the moment and just doesn’t seem to want to put in a decent correction. Dips are bought with gusto. It’s a sign of a powerful bull market when everyone seems to be waiting for a correction and it doesn’t happen.
The bull market in gold is the mirror image of the bear market in government policymaking and fiat currencies. The trend has a long way to run yet.
Closer to home, RBA governor Glenn Stevens was out last night talking about the terms of trade again. Unusually for a central banker, this was a thoughtful speech about how Australia should think about managing the recent jump in the terms of trade.
As you can see from the graph Stevens presented in his speech, the recent spike in the terms of trade is up there with past historical increases. The question he raises is whether it’s a permanent or temporary shift in our fortunes.
The terms of trade, by the way, measures the value of our exports in terms of imports. As Stevens puts it, ‘when the terms of trade are high, the international purchasing power of our exports is high.’
Stevens correctly points out that history suggests the huge increase in the terms of trade will be temporary. He just doesn’t know when the temporary bit will kick in.
If it is, he says that ‘it would probably not make sense for there to be a big increase in investment in resource extraction if that investment could be profitable only at temporarily very high prices’In other words, Australia’s resource sector could ‘probably’suffer from overinvestment if it turns out that China’s insatiable appetite for iron ore and coal is more a product of its massive credit boom than anything else.
Has Glenn Stevens been reading a bit of Ludwig von Mises lately?
Of course you don’t have to have studied Austrian economics to come to that conclusion, you just need common sense. Surprisingly for a central banker, Stevens seems to have plenty of it.
But let’s not get too excited. There is always ‘the other hand’.
‘On the other hand, experienced people seem to be saying that something very important – unprecedented even – is occurring in the emergence of very large countries like China and India. If the steel intensity of China’s GDP stays where it is already, and China’s growth rate remains at 7 or 8 per cent for some years to come, which appears to be the intention of Chinese policy-makers, then the demand for iron ore and metallurgical coal will rise a long way over the next couple of decades.’
Translation: ‘This time is different.’