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The best way to bet on another crisis in the eurozone
Despite the European Central Bank's best efforts, the euro keeps rising. It looks like Mario Draghi will be forced to act – but when? John Stepek investigates.
All around the world, other central bankers are printing money with gay abandon, or promising their populations that there's no chance interest rates will rise any time soon. And everyone's only too happy to believe them.
Yet, although the ECB actually cut interest rates at its last meeting, no one really believes its heart is in it.
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Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.
Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.
Typically, when rates fall, you'd expect the currency of that country (or region), to fall too. But the euro has continued to rise inexorably, despite the best efforts of ECB boss Mario Draghi to talk it down.
The big question is where's Draghi's breaking point?
Central banks don't usually have a problem with printing money
If there's one thing that markets love, it's when a central banking regime starts to make promises it can't keep. It's one of the rare occasions in investment where you get the chance to bet on a sure thing'.
Take George Soros' big bet on the pound back in the early 1990s. The British government swore to keep the country in the European Exchange Rate Mechanism. But it had a finite amount of ammunition, and there was only so far it could raise interest rates before the entire country squeaked. All traders had to do was keep selling the pound until the Bank of England was forced to give in.
When it's the other way around with a country threatening to weaken its currency it's much trickier. After all, with money printing and quantitative easing (QE) available, there's no real limit to a central bank's ability to debase its currency. So if you're betting on a currency to go higher, and the central bank starts muttering about the strength of that currency, it's usually a warning sign to be on your toes.
Mario Draghi at the ECB has every reason to wish for a weaker euro. The plight of the peripheral' countries has dropped out of the headlines somewhat in the last year or so. But those nations are still in trouble.
Capital Economics reckons that Portugal will need a second bail-out. Greece is still in a mess (regular MoneyWeek magazine columnist Matthew Lynn thinks a Grexit' could be back on the cards next year). And neither Spain nor Italy are out of the woods by a long chalk.
These countries have huge debts and little real chance of paying them off. Your usual course of action (and the one the UK and the US are trying to follow) is to inflate your way out. But because they are stuck with the euro, this isn't a course of action that's open to these nations.
The alternative is to write off their debt and force their creditors to swallow the loss. That's been partly done by Greece already. But again, it's not really an option that's open to the others. No one would lend money to any other even moderately troubled eurozone country if they thought that default was a realistic policy option.
So the ECB is effectively pinning its hopes on a future economic recovery, which would enable these nations to grow their way out of trouble. Meanwhile, Draghi has bought time by promising to do "whatever it takes" to underwrite the eurozone. And so far, markets have taken him at his word.
The trouble with deflation
But there are hints that markets are running out of patience.
The eurozone recently posted very weak inflation data. That's a bit of a problem when countries are hugely indebted. Here's how to look at it. Once debt reaches a certain level (different for every country and every individual) it becomes a weight, pressing down on your potential growth. Resources that could be better deployed elsewhere instead have to be spent on servicing interest on the debt in other words, a lot of energy goes into simply holding up this crushing weight.
For a debtor, gentle inflation is a benign force that nibbles away at the weight each day, making it that little bit lighter. But if deflation kicks in, the real' value of debt starts to rise. So the weight gets heavier, and requires even more energy to go on debt servicing. Keep going, and the debtor gets squashed.
So that's not the sort of environment that's conducive to a recovery in the likes of Greece. And the more investors start to fret about that, the more they might realise that the recent lull in the eurozone has been just that a period of breathing space, not an end to the crisis.
If Draghi really wants to make life a bit easier for these countries, and continue buying time, then his only real option is to aim for a weaker euro. He might not say it out loud partly because the Germans would have a fit but he'd really like the euro to be a lot lower than where it is today.
Hence the interest rate cut. And hence the range of ECB representatives who've been muttering about the possibility of negative rates. The idea is to make the market worried that the ECB is just one step away from doing something dramatic.
Trouble is, everyone knows this. And everyone knows that the ECB is also hemmed in by politics. So the constant jawboning' is starting to take on a feeling of desperate pleading "Honestly, we can debase our currency too!"
And the market is now starting to call the ECB's bluff. After a brief slide, the euro is now higher than it was before the interest rate cut came. Investors are ignoring veiled threats from ECB executives. They're now saying: "You want a weaker euro? Prove it."
Why the eurozone probably needs another crisis
I suspect that the euro will have a painful plunge at some point in the future. But it's very hard to say when. And I also suspect that the euro will have to test the ECB's pain barrier before it has a proper' crash.
It's not unlike Japan. The yen just kept on relentlessly making fresh new lows against the dollar, until the country couldn't take it any more. In came Shinzo Abe, out went the old central banking regime, with a whole load of quantitative easing. They might say publicly that the yen isn't the target. But the truth is that battering the currency has worked out rather well for them so far.
The ECB may well be on the same path. So the euro could go higher before it gets any lower.
That's why a better way to bet on the ECB eventually being forced into money-printing or something similar, is to buy eurozone shares. Unlike with foreign currency trading, you don't have to get your timing right.
Ongoing exuberance around the world means that investors are keen to buy anything that looks even relatively good value as a catch-up' trade. And whenever the fresh crisis materialises, while shares will no doubt take a hit at that point, when the ECB is eventually forced to act, you'll be able to benefit from that too.
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