Don’t get too comfortable – the eurozone crisis isn’t over yet

Last week, the markets welcomed a prodigal borrower back into the flock.

Greece – a country with a history of lying about its national finances, and which effectively defaulted on a chunk of its debt only a few years ago – was embraced with open arms by lenders hungry for yield.

Is this a sign that the eurozone crisis is over?

Or is it just more evidence that prolonged financial repression has finally driven investors over the edge in their desperate search for returns?

Europe isn’t fixed yet

Markets are textbook examples of crowd psychology in action. Sometimes you can scare them off easily if you wield the right big stick.

At other times, they’re more like a pack of sharks. Give them a sniff of blood in the water and there’ll be a feeding frenzy.

European Central Bank boss Mario Draghi is a smart guy. He scared the markets into submission in 2012 with his “whatever it takes” speech.

Since then, borrowing costs for countries across the region have tumbled. The break-up of the eurozone has gone from being a near-certainty to vanishingly unlikely. And it’s all because investors came to believe that Draghi would do what his predecessor would not – print money to buy government bonds.

Trouble is, while this has bought time, it hasn’t solved the underlying problems yet. Europe’s banks are still broke. They are a long way behind the US and even the UK in terms of being fixed.

Draghi is hoping to sort out the banks later this year with the ‘Asset Quality Review’ (AQR). The idea is to find out just how big a mess the banks are in, and force them to tackle it by raising whatever capital they need.

That’s a good thing. Some sort of transparency on the state of the banks would at least give a better idea of how long repairs might take. But in the meantime, if the banks aren’t fixed, they aren’t lending money. And if they’re not lending money, it’s hard for the economy to grow.

The solution in the US and the UK was for the central bank to pump lots of money into the system via quantitative easing (QE). This was in effect a huge subsidy for the banks, paid for by taxing savers. The markets stabilised, the banks got some easy profits from QE, and they also won time to write off bad debts and repair their balance sheets.

The process is ongoing (our regular contributor James Ferguson of the MacroStrategy Partnership wrote about this in a recent issue of MoneyWeek magazine). But it’s closer to the end than to the beginning.

That’s not the case in Europe. And the danger now is that without some form of more aggressive money printing from the ECB, the eurozone’s poorer economies will be left struggling under the weight of their own debt, getting ever deeper into trouble.

Three little words that sum up the trouble with the eurozone

We all know what the problem with the eurozone is. You can sum it up in three words: “Greece isn’t Germany”.

The right economic policies for Germany are the wrong ones for Greece. The right currency level for Germany will crush the Greek economy like a ripe olive in a press.

The German response is: “Well, the Greeks should be more like us then.” You can have a bit of sympathy with that. The Greeks could certainly do with pulling together a functional tax collection system. Making an effort to stop the more egregious examples of corruption would help too.

So yes, the Greeks could do with reforming their economy. But it’s not easy to do that when you’re also worried about being stuck in a giant olive press that’s crushing the life out of you.

Greece might have gained access to foreign capital again. But it’s not because the economy looks a lot better. It’s because investors will buy any old rubbish that they believe is underwritten by central banks.

Ultimately, if you want to fix Greece, but you also want Greece to stay in the eurozone, the Germans (the ‘savers’ in this context) need to pay to bail it out.

This is why Draghi keeps trying to ‘talk down’ the euro. A weaker euro takes a bit of pressure off the weaker countries. It’s also one action that Draghi can take without having to run the gauntlet of German opposition.

Will Draghi be forced to do QE?

Trouble is, talk only goes so far. Draghi has got by on ‘talk’ ever since that 2012 speech. But now markets are testing him. The euro is horribly close to the $1.40 mark that seems to be Draghi’s line in the sand.

There are lots of options for Draghi. Negative interest rates, or some form of QE, have all been discussed, he says. The big question is: what will it take to get him to act?

As far as I can see, there are two possible outcomes here. Either Draghi gets his way and starts to do something instead of just talk about it. Or it turns out that Draghi’s hands are tied by Germany, and we’re forced to another crisis point  – perhaps by a surging euro – before he is able to push anything through.

One way or another, I suspect we’ll get some form of stimulus for the eurozone later this year. But the longer this continues, the wobblier markets will get.

I’m still a fan of cheap eurozone markets – they’ve done very well in the past two years and I expect that’ll continue. But we might get a good buying opportunity later in the year if Draghi can’t convince his German colleagues to act without another crisis to force the issue.

As for the euro – I think it’ll end the year weaker than it is now. But in the short term, markets will start looking for any excuse to drive it higher and call Draghi’s bluff. So if you’re thinking of trading the single currency, just be aware that every time Draghi opens his mouth, you can expect turbulence. (And if you are interested in trading currencies, you should sign up for our free regular email MoneyWeek Trader before you do so.)

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