The fortieth anniversary of the pan-European currency is only weeks away. On March 13, 1979, the European Monetary System (EMS) with its Exchange Rate Mechanism at the time, the ECU was born. After many rounds of tough negotiations and opposition from the United Kingdom, the Maastricht Treaty of 1993 created an economic and monetary union in 1999 which exchange the ECU for the euro currency. While the euro came into being in 1999, it was not until 2002 when euro notes and coins became to circulate and take over from the former national currencies. The German mark, French Franc, Dutch Guilder, Belgian Franc, Spanish Peseta, Portuguese Escudo, Italian Lira, Greek Drachma, and many other member currencies disappeared with the euro as the means of exchange for most members of the European Union. While the Danes and British opted to keep their currencies, the majority of Europe adopted the euro as the only foreign exchange instrument.
Aside from incorporating many currency instruments, the euro and EU became a blend of many diverse cultures and orientations to managing the member nation’s finances. The starkest differences appeared between the southern and northern European members of the EU which led to more than a few problems over the almost two decades since the euro currency became the exchange instrument for the Union.
While there is strength in numbers and the EU has created economies of scale within its membership, cultural divides have made monetary policy and managing the purse strings of the union a challenge. The gaps continue to weigh on the value of the euro currency as its twentieth anniversary as a foreign exchange instrument is this year. The Invesco Currency Shares Euro ETF (FXE) is a liquid product that tracks the performance of the US dollar versus the euro currency.
Not only does it not offer a short-term yield, but it also costs to hold the currency
Since the 2008 global financial crisis, massive liquidity from both the US Federal Reserve and the European Central Bank have weakened the dollar and the euro by running currency printing presses at unprecedented rates. While the US has moved to tighten credit and reduce the level of liquidity through short, medium, and long-term interest rates since late 2015 on the short end of the curve and since 2017 when it comes to quantitative easing, Europe’s efforts to reverse the effects of a decade of unprecedented monetary policy accommodation have lagged.
At the latest ECB meeting, President Mario Draghi told markets that while the program of QE came to an end at the start of this year, the central bank could use asset purchases in the future if the economic conditions worsen. At the same time, the ECB gave no timetable for reducing their balance sheet nor did they give any indication that short-term rates will rise from the negative forty basis point level in 2019. President Draghi’s term ends in October 2019, so it is unlikely that he will preside over the monetary authority when the rate begins to rise and heads towards positive territory.
The US dollar and the euro are the two leading reserve currencies in the world. The current short-term Fed Fund rate puts the yield on dollar deposits at 2.25-2.50%. At negative 40 basis points, there is a 2.56-2.90% differential between the dollar and the euro when it comes to reserve holdings. Moreover, holding euros involves a storage cost as a negative yield means owners of the currency pay for the privilege of owning the European currency. The theory behind a negative return is that it encourages spending and borrowing while it inhibits saving to stimulate the economy. When compared to the dollar these days, holding euros is a losing proposition when it comes to yield.
The European economy is sluggish, at best
The yield differentials between the two reserve currencies reflect the stark contrast in economic conditions on opposite sides of the Atlantic Ocean. In the US, tax and regulatory reform have led to an economic boom with GDP growth at over 3% and unemployment at the lowest level in decades. In Europe, the latest news is that German and Eurozone growth is lethargic, unemployment remains high, and the prospects for 2019 are not all that bright of any type of recovery.
When it comes to currencies, interest rate differentials are one of the leading factors when it comes to the path of least resistance for exchange rates. The yield on the dollar and economic growth in the US continues to overshadow the cost of holding a euro and weak economic conditions in Europe.
The ECB has little room in its toolbox
Quantitative easing was a post-2008 financial crisis invention that helped central banks in the US and Europe push interest rates lower further out along the yield curve in the interest of stimulating economic growth through spending, borrowing, and investment. In the US Fed Chairman Ben Bernanke, who was a student of the Great Depression, came up with the QE tool and Europe followed in his footsteps. While the US Fed only purchased US government debt securities, the ECB expanded the parameters to include some “high-quality” corporate debt issue. Additionally, European QE continued long after US QE ended, and after the US began to unwind the legacy of the program through balance sheet normalization that started in October 2017.
At the January ECB meeting, after the program had ended less than one month before, the head of the ECB left the door open for more periodic debt purchases depending on economic conditions.
The ECB has no stated program to reduce their swollen balance sheet, may add to it under certain circumstances, and has no plan to increase the short-term rate from its current negative level. Given the continuation of an uber-dovish approach to monetary policy, President Draghi and whoever his successor turns out to be, have little room in their toolbox for more stimulus regardless of the economy without the risk of setting off a period of accelerating inflation and destroying the value of the still young euro currency.
A reserve currency, but not an attractive option
The euro is not an attractive currency these days, from a yield perspective. Moreover, the constant pressure and bickering between the austerity of the northern members of the Union and loose attitudes of the southern members when it comes to controlling the purse strings weigh on the prospects for the euro. At the same time, slower Eurozone and German growth expectations, economic problems in France, and Brexit all add up to a financial nightmare for the Europeans over the coming weeks, months, and years. When it comes to Brexit, these days, the ECB and EU can only hope that the negotiations with the British can continue after the March 29 deadline. The last thing Europe wants is a precedent for an easy escape from the clutches of the EU for any members who decide that they too want a divorce on the back of a political whim.
The prospects for the euro currency are not good these days when it comes to the value of the notes and coins that have nothing but the full faith and credit of the EU behind them. However, what is likely holding the currency at its current level and may even make it rise against the dollar and other foreign exchange instruments is that paper money is not what it used to be before the 2008 crisis.
Yogi Berra, the late great baseball catcher, manager, and armchair philosopher once said, “The future ain’t what it used to be.” For the euro, its short history was changed dramatically by the central bank tools that flooded the markets with liquidity which means, cheap euros. Heck, the central bank is still paying borrowers on a short-term basis to take the paper. I wonder what Yogi would have said about the current situation. Perhaps he may have opined, “If you are paying me to hold your money, I’d rather have cash.”
While the dollar has appreciated against the euro since last February, at least in part because of the rate differentials and contrasting economic conditions, the US currency also suffers from political discord in the form of divisiveness on the domestic scene and a trade dispute with China because of protectionist policies.
These days, the real reserve currency of the world is the one that central banks continue to be net buyers of and is the oldest means of exchange in history.
Are all currencies weak? Gold thinks so – FXE is a wasting asset, and it is not even leveraged
Gold is the yellow metal that has been a symbol of wealth and currency for thousands of years. Long before the dollar, the euro, and all of the ancient European currencies that became extinct at the turn of this century were legal tender, gold was and still is hard money. The fact that central banks continue to hold gold as part of their foreign currency reserves and have been net buyers of the yellow metals over the past years should tell us that governments respect the value of the precious metal more than their legal tender or that of the other nations of the world. The chart of gold in the dollar and euro terms since mid-August is a commentary on the current state of the foreign exchange market.
In dollar terms, April gold futures on COMEX are up from a low at $1182.70 on August 16, 2018, to $1312.60 on February 11, an increase of 11%.
Since the same date, gold in euro-terms has moved from E1034.71 to E1160.80 or 12.2%. Gold has also appreciated over the period in Japanese yen, Swiss franc, Australian and Canadian dollars, Chinese yuan, Russian rubles, and almost all foreign currency exchange terms. If Yogi Berra were still alive, he would opt for gold as he would say, “It’s the only thing that is as good as money these days.”
I have been thinking a lot about the euro and have been watching the ups and downs of the Invesco Currency Shares Euro ETF. Those who read my many pieces on Seeking Alpha know, I often warn of the perils of leveraged ETF and ETN products. The leverage that creates double and triple performance comes at a price which is time decay. The longer you have to hold these instruments they uglier they become as timing is the most significant factor when it comes to leverage. Many market participants find their portfolios littered with dust collectors that are the remnants of leveraged ETF products that held for too long.
The FXE ETF has the potential of becoming one of those products that owners sit on like a hen waiting for an empty egg to hatch. Negative interest rates mean that the FXE is an asset that decays even though it is not leveraged. On the other hand, the Market Vectors Double Short ETN (DRR) will experience gains over time if the euro currency remains stable in the current interest rate environment as the implied yield is twice the interest rate differential between the dollar and the euro currency. However, DRR only has $10.52 million in net assets, and the average daily trading volume of 461 shares makes it a roach motel when it comes to liquidity. The bid-offer spread could make it easy to get into a long position, but more than a challenge to get out.
The fund summary for the more liquid FXE states:
The investment objective of the Trust is for the Shares to reflect the price in USD of the Euro. The Shares are intended to provide institutional and retail investors with a simple, cost-effective means of gaining investment benefits similar to those of holding euro.
FXE has net assets of $235.61 million with an average of 281,873 shares trading each day. For those who do not like the prospects for the euro against the dollar, a short position in this product could offer the best chances for success with the added attraction of a negative yield.
As you can probably tell, I am not a fan of currencies that have the backing of the full faith and credit of the governments that print the legal tender these days. Years of mountains of liquidity have changed the dynamics of currency values. Some market participants are pointing to the demise of the currency markets as justification for a bullish view on cryptocurrencies like Bitcoin and the other over 2000 tokens that have burst upon the scene. However, I think that the current environment favors the oldest means of exchange in the world and that is gold.
Yogi once said, “You can observe a lot by just watching,” and the state of the currency markets and trend in gold are telling us that real value is in the yellow metal, while the paper “ain’t what it used to be.”
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