Europe's Feint

The euro has been sold hard across the board in recent days, taking numerous investors and observers by surprise. After all, the European sovereign debt crisis that was so threatening earlier this year had been resolved, the fiscal austerity measures announced had re-earned the market’s confidence, and the economies had strengthened in Q2 after nearly stagnating in Q1. No less an authority that the ECB President himself suggested that Q3 was off to a fine start.

At the same time, we are told that US policy makers have no sound fiscal strategy and under the weight of structural problems. Additionally the world’s biggest economy slowed down sharply in Q2 after above trend growth in Q4 09 and Q1 10. So what happened that sparked a nearly 5% drop in the euro over the past few days?

Returning to the Scene of the Accident

The most compelling explanation requires returning to the European crisis. There was a liquidity dimension to the crisis and a solvency component. Officials addressed the first by increasing the liquidity facilities and provisions by the ECB, altering collateral rules for borrowing from it, and purchasing covered and sovereign bonds in the secondary market.

Europe bluffed its way through the solvency issue. Besides a direct EU-IMF package for Greece, European officials claimed to have put together a 750 bln euro facility. They did no such thing.

While, 250 bln euros was to come from the IMF, the multi-lender made it clear that it does not lend money to regions, but rather to specific countries on specific conditions. Outside of the two tranches that have been paid to Greece since May, the IMF has not given a single euro to the euro zone.

Another 60 bln euros was to come from the EU itself. Some countries that are members of the EU, but not of the monetary union, like the UK, object to subsidizing the euro zone. Those funds have also not been forthcoming.

That leaves the heart of the program, the 440 bln euro European Financial Stability Facility (EFSF). The funds are essentially guarantees that will be used to issue bonds when needed. There is less here too than meets the eye. Germany, for example, has blocked the ability of the EFSF to raise funds preemptively (pre-fund). This guarantees that it can only be used after the fact, when a crisis is already unfolding and when markets would be the most volatile.

European officials want the EFSF bonds to carry a triple-A rating. Yet 10 of the 16 euro zone members do not have such a rating themselves. A triple-A rating only possible if the ratio of loan-to -guarantee is less than 1. To say this another way, the EFSF has to secure greater guarantees than the loan amounts in order to secure that highest rating.

Reports suggest that it was agreed that there would be 20% greater guarantee than loans. After excluding the “suggestive” IMF contribution and the EU’s contested contribution, and the haircut needed to ensure triple-A rating, the “shock and awe” of the 750 bln euro effort is cut in half to 365 bln euros.

This may still seem substantial especially if one thinks the next crisis will be contained to a single small country, such as Greece or Portugal or Ireland. . But it might not be sufficient if two small countries had their backs against the wall, or a large country, like Spain or Italy for example, were desperate.

It is not just the amount of funds that are available that is open to question, it is also the credibility. After much debate, Slovakia’s new government agreed to maintain the previous government’s commitment to the EFSF, however it withdrew from the Greek facility. This speaks to the fact that is as important today as it was three months ago: Europe is still a collection of nation-states with powerful independent political pressures and a weak center. Under a scenario in which there is contagion, can investors be sure that Italy, for example, would guarantee funds for Portugal or Ireland, on top of Greece?

Growth: The Elixir

Still the confidence game can work, provided there is a sufficient appetite for risk by investors and global growth is supportive. That is the wheel that has fallen off the cart in the past few days.

Recent data from the world’s three largest economies (the US, China and Japan) has mostly surprised on the downside. Several European countries, including Germany and the UK, reported unexpected declines in June industrial production, raising the possibility that ECB President Trichet was premature in his assessment of the euro zone economy.

In some under-appreciated ways, what happened in recent weeks is similar to what happened in July 2008. The ECB raised interest rates. This was a serious policy error and we argued so at the time. To be sure, the ECB has not hiked rates, but the euro zone has been subject to monetary tightening, an appreciating currency, and promises of higher taxes and/or cuts in government expenditures.

The monetary tightening can be seen in the contraction of money supply and the decline in outstanding ECB loans. Three-month Euribor had risen sharply, though it has eased alongside the euro in recent days. Fiscal consolidation is a program that won't meaningfully begin until next year, except on the periphery, though surely households and businesses will take it into account when making decisions now.

The point is that neither Europe nor the world economy appears to enjoy the kind of economic momentum needed to square the economic circle, which is to stabilize debt to GDP ratios. Such an economic climate has direct bearing on the investment climate. And in such an investment climate Europe still looks vulnerable.

Stressed Out

Reasonable people can differ over the merits of the recent European bank stress tests. The fact that Greek, Italian and Portuguese banks (the only countries for which data was readily available) increased their borrowings from the ECB in July warns that the stress tests may not have been as successful as other indicators, like share prices and bond sales, would suggest. Greek banks increased their borrowings from the ECB by 2.5%; Spanish banks by 3%, Italian banks by 12% and Portuguese banks by 20%.

Reports indicate that Spanish regional governments, including Catalonia, which accounts for a fifth of Spain’s GDP, continues to be frozen out of the capital markets. Other reports suggest that Galicia is seeking to freeze its debt servicing to the central government.

In recent days Ireland has been the region’s lightening rod, illustrated by the fact that the premium it pays over Germany rose about 50 basis points in five days to almost 290 bp compared with the 306 peak at the height of the crisis in May. The EC approved a government injection of another 24.5 bln euros into one of Ireland’s largest banks, which is about 10% more than the finance minister had indicated the previous week.

European central banks had been winding down their sovereign bond purchases in recent weeks, buying only enough to prevent investors from concluding that the program was finished. In recent days, there had been market talk that they returned to buy short-dated Irish bonds. Stress in the region is evident also by the elevated credit-default prices, which in Ireland’s case are at new highs for the year.

What’s Next?

Investors should monitor bank borrowings from the ECB, reported by member central banks, and watch the credit-default swaps. Track how prices respond to fundamental news and expectations. The euro is likely to be very sensitive to global growth and domestic growth issues – leaving it vulnerable to negative surprises.

Europe's financial challenges have not been resolved, despite the euro’s recent recovery. Its bluff is more likely to be called in a weak growth and low risk tolerance environment. With the US now experiencing slower growth than in Q4 09 and Q1 10 , and having what appears to many investors as an intractable fiscal problem, the “equilibrium” rate for the euro-dollar exchange rate, while probably a bit higher now than it was six months ago, may still be below prevailing levels.

Chart-based considerations suggest that the $1.2350-$1.2500 band will likely be strong support for the euro, requiring then a more marked deterioration of conditions in Europe, or an unexpected string of stronger US economic data. On the upside, the $1.30-$1.31 area should cap the euro, if the most recent downtrend that began last November is to continue.