New European Governments Provide No Remedy

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New governments are put in place, but it is becoming clear that it this will not help. The foundations and the basic expectation of creating growth with austerity are the problem here.

Christopher Vecchio, a currency analyst with DailyFx.com discusses the European debt crisis, the impact of a possible failure of the US “Super Committee” to reach a deal on markets, the sensitive situation of the British pound and more.

1) Will the new governments in Greece, Italy and probably Spain be able to contain the current crisis? Or will the upcoming recession escalate the situation?

The upcoming recession will exacerbate the dire situation unfolding in Europe. The new governments were supposed to usher in a wave of broad investor confidence, a suggestion that the leaders in charge were holding back their respective countries from righting the Euro-zone ship. This has not been the case. The Greek government continues to pander about its business, having been unable to produce a written statement affirming its commitment to the Euro-zone bailout. Similarly, incoming Italian Prime Minister Mario Monti was supposed to be a savior-of-sorts for the Euro-zone’s third largest nation; instead, he is having trouble reaching quorum on a new cabinet.

It is becoming more evident with each passing day that it is not the leaders in charge who are the problem, but rather the foundation by which the world’s most developed economies rest upon. A key tenet of the current system is that governments would be able to run structural deficits in perpetuity while rolling over debt obligations; the Greeks certainly believed this when they entered the Euro-zone and became cordial with lower borrowing costs.

As long as the current remedies set forth to resolve the crisis remain unchanged – attempting to promote growth while inducing austerity measures – the structural issues will weaken further and the foundation the Euro-zone rests upon will deteriorate further, ultimately until the Euro-zone, in its current form, ceases to exist.

2) The deadline of the US “Super Committee” is getting closer, while politicians on this committee aren’t getting closer. Do you think that a failure to reach a deal will have an impact on the markets?

A failure will roil markets ala early August 2011, but a failure is not the only concern. It is important to keep in mind that a bipartisan agreement was reached ahead of the U.S. debt deadline, but Standard & Poor’s downgraded the federal government’s long-term debt rating – as it should have – considering none of the structural issues plaguing the country were fixed (note that this isn’t just the case in Europe, but across the world’s most advanced economies).

The major rating agencies have already indicated that a downgrade may be on the horizon unless the United States reshuffles its fiscal house in an order that the deficit can be reduced at a sustainable rate over the coming years, without too much of a burden on the economy. This remains to be seen, but with politicians remaining distant on opposite sides of the isle, the situation looks bleak at best. Given the tense climate surrounding the current election cycle, the negotiations appear to be taking a similar form to those that were held over the summer. Using that as a guide, while the Super Committee may come forth with budget reduction plans as the clock approaches midnight, they are likely to be insufficient.

As such, higher yielding currencies such as the Australian Dollar and riskier assets such as stocks are looking towards a turbulent end of the year, as the Super Committee fails to enact the necessary measures to bring the United States’ debt under control, while the Euro-zone crisis spills over, leading to the eventual dismissal of one of the periphery countries at some point in 2012.

3) Britain managed to distance itself from the euro-zone debt crisis and its bonds also enjoyed a “flight to quality”. On the other hand, the strong economic ties with continental Europe mean that euro-zone trouble impacts Britain. How will another euro-zone deteriorating impact the pound?

The British Pound looks to appreciate against the Euro as capital flows shift into safer economies – the United Kingdom is certainly safer than the Euro-zone on the whole – but overall the British economy will suffer. The United Kingdom and the Euro-zone have inextricable links, similar to the relationship that Canada has with the United States. The British economy is already facing immense headwinds, with the inflation rate approximately two-times greater than the Bank of England’s target, while the labor market remains depressed amid subdued growth.

The Bank of England is actively working to avoid a deflationary environment by pumping credit into the system, but by doing so, they are exposing their economy to a severe stagflating state should the Euro-zone enter a recession, or worse, disband from its current form. Given this outlook, the Sterling looks lower against the Japanese Yen and the U.S. Dollar, while it is poised to gain against the Euro and the higher yielding currencies, as investors shed risk for safety in the coming weeks.

4) There are various opinions about the state of the Australian economy. Do you think that the RBA will cut the rates in December as well?

It does not appear that the Reserve Bank of Australia will cut rates in December, should the current economic situation persist. As per the Board’s minutes released at the start of trading in Asia on Tuesday, Australian policymakers believed that there was a case to keep the key interest rate at 4.75 percent, instead of cutting the rate to 4.50 percent. Likewise, considering their outlook for the Australian mining sector remains robust, aside from falling inflation, there exists little reason to cut rates again.

On the other hand, if markets undergo siege due to the Italian and Spanish bond markets falling apart, or the Congressional Super Committee offering insufficient terms for reducing the United States’ deficit, the Reserve Bank of Australia may be forced to cut rates to keep liquidity flowing amid a major market sell-off.

5) Yet again, another Japanese intervention in currency markets had short lived success. Do you think that the BOJ will continue intervening? Or will the recent strong GDP figure enable the authorities to stay out of the markets?

While the Bank of Japan hasn’t intervened since March, the Ministry of Finance has intervened twice since then, with the most recent move to weaken the Japanese Yen on October 31. By all indications, this is expected to continue. Finance officials suggest that the Yen remains significantly overvalued relative to Japan’s fundamentals, and that isn’t a far-fetched statement: Japan has the world’s highest debt-to-GDP ratio, near 220 percent – well-above the American, Greek and Italian ratios.

Given my outlook for increased market turmoil and volatility in the coming weeks and months, the Yen stands to strengthen further as investors shift their capital into more liquid and safe assets. To curb the excessive appreciation that is on the horizon, I expect one of the two Japanese governmental bodies to step back into the markets and make another statement by propelling the USD/JPY above the psychologically significant 80.00 exchange rate.

You can follow Christopher Vecchio on Twitter: @CVecchioFX

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Yohay Elam – Founder, Writer and Editor I have been into forex trading for over 5 years, and I share the experience that I have and the knowledge that I’ve accumulated. After taking a short course about forex. Like many forex traders, I’ve earned the significant share of my knowledge the hard way. Macroeconomics, the impact of news on the ever-moving currency markets and trading psychology have always fascinated me. Before founding Forex Crunch, I’ve worked as a programmer in various hi-tech companies. I have a B. Sc. in Computer Science from Ben Gurion University. Given this background, forex software has a relatively bigger share in the posts.