Traders are picking on the euro again

Jan 28th 2012 |From the print edition

BARELY a week goes by without a report on the level of confidence among consumers, businesspeople and investors. Optimism is what's wanted—Keynes talked of the “animal spirits” that influence economic activity. Pessimists are routinely denounced as Jeremiahs. Those who try to bet on falling prices find their activities are restricted.

A cheery disposition may be necessary for societies to function. Daniel Kahneman, a psychologist and Nobel economics laureate, has a chapter in his book “Thinking Fast and Slow” which describes overconfidence as “the engine of capitalism”. No entrepreneur can be sure that his planned investment will succeed but if no one took a risk, new products and jobs would never be created. A certain blindness to the odds may be necessary. According to Mr Kahneman, the chances of an American small business surviving for five years are just 35%. But ask individual entrepreneurs about their prospects and 81% think they have a better than seven-in-ten chance of success.

This self-confidence may be innate, just as most people think they are better-than-average drivers. And it would seem logical that the most optimistic people gravitate towards entrepreneurship. That is good for consumers, who can select from a wider variety of products. Even the failed businesses serve a purpose. Daniel Gross, a journalist, wrote a book claiming that bubbles were good for economies since they leave behind infrastructure (canals, railways, fibre-optic cable) that can last for generations.

But it is hard to make such a case for all bubbles. Anyone who has driven past a row of empty houses in the Irish countryside will realise that optimism can lead to wasteful investment. And Mr Kahneman cites studies that show how overoptimistic chief executives (as measured by the amount of stock they own) were more likely to gear up their balance-sheets and pay too much for acquisitions.

The problem with overoptimism was illustrated by the investment-bank collapses of 2008. The men who reached the top of such risk-taking organisations had, by definition, been successful in their previous bets. They believed this was due to skill, not luck, making them too sanguine about their ability to ride out the crisis.

A further problem with optimism is thus that it is pro-cyclical. The greatest moment of success for optimists will occur at the peak of a boom, when they will feel their instincts have been justified. Previous house-price rises will make buyers more optimistic about borrowing more money; and banks will be more optimistic about the prospect of being repaid.

Financial assets are highly unusual in that rising prices tend to elicit higher demand. Analysts extrapolate recent rapid profits growth into the future, even though profits cannot rise faster than GDP indefinitely. If markets were truly efficient, price-earnings ratios should be lower than average at the top of the cycle, since investors should anticipate a reversion to the mean. Instead, high p/e ratios and rapid profits growth tend to go together.

It used to be the role of central bankers to take away the punchbowl when the party was in full swing. Under Alan Greenspan, however, the Federal Reserve ended up spiking the punch with more rum by cutting rates whenever markets wobbled. The hope is that in future central banks will keep an eye on asset bubbles under the guise of “macroprudential” policy. This might involve the use of broader measures than just interest rates. For example, the Fed could pop housing bubbles by imposing a maximum loan-to-value ratio for mortgages.

But what if the bubble this time is in government bonds, not equities? The last time long-term Treasury bonds yielded 2.1% was in 1949. Investors who took the plunge into Treasuries then earned an annual negative real return of 1.6% over the following 30 years.

On this occasion, however, the central bank is one of the main purchasers of Treasury bonds in an effort to keep yields low. Such low yields could be attributed to optimism that American politicians will agree on a long-term plan to sort out the government's finances. But it seems likely that the main driver is pessimism about the outlook for other asset classes.

In this case the gloom seems entirely beneficial. Low rates stimulate the economy and are good news for the American government, which can finance its deficit cheaply and without facing the dilemmas that beset the Italian and Spanish governments, which must impose austerity at a time of economic slowdown. But the pessimists can't expect to be thanked.

^{Economist.com/blogs/buttonwood}

From the print edition: Finance and economics

Traders are picking on the euro again

Jan 14th 2012 |From the print edition

ALTHOUGH 2011 was filled with headlines about the potential demise of the single currency, the euro did not actually fare that badly in the foreign-exchange markets. Its trade-weighted decline for the year was only 3.3%.

But traders went into 2012 betting on a further fall. Figures from the Commodity Futures Trading Commission showed a record short position in early January. Sure enough, the euro slipped below $1.27 in the year's first trading days, before recovering slightly.

Before predicting a collapse in the euro's value, however, it is worth remembering a couple of salient facts. Markets often make sharp moves in the first days of January that are not sustained in the rest of the year. The euro fell by 3.6% against the dollar in early 2011 before stabilising. The presence of so many bearish bets is a classic contrarian signal that all the bad news may be in the price.

Secondly, foreign-exchange markets are an “ugly contest” in which traders and investors have to pick the least-worst currency. Most developed countries would like to see their currencies fall in order to help their exporters. Switzerland is trying to cap the level of the franc. Japan has repeatedly intervened to prevent the yen from strengthening too far. America has seen its debt downgraded by Standard & Poor's and runs its fiscal policy via a series of 11th-hour compromises.

So what explains the current bias against the euro? There is some evidence that central banks are losing enthusiasm for diversifying their reserves into euros. Between the third quarter of 2009 and the same period last year, the euro's share of central-bank reserves fell from 27.9% to 25.7% and the dollar's proportion nudged up slightly from 61.5% to 61.7%. It seems as if central banks have been spreading their net more widely into the likes of the Australian and Canadian dollars.

There have also been signs that the American economy is doing rather better than its European counterpart. Whereas the euro zone may already be in recession, America could enjoy a year of “trend” growth. The labour market is improving, as are other signs of confidence such as house purchases and car sales.

In addition the link between the dollar and the “risk on/risk off” trade may be weakening. Ever since the financial crisis, the dollar has tended to do best when investors are cautious (the risk-off phases) and to fall when they are feeling optimistic. Perhaps American fund managers were selling dollars to buy foreign assets when in upbeat mode and bringing their money back home at more downbeat moments. But their appetite for foreign equities may be waning, especially since Wall Street outperformed European stockmarkets in 2011. So far in 2012 both equities and the dollar have risen.

For much of 2011 the euro also had a clear yield attraction over its main rivals (the dollar, yen and sterling). But two rate cuts in the autumn have brought euro-zone rates down to 1% and further cuts are expected later this year. There is talk that the euro is now being used for carry trades, whereby investors borrow in a low-yielding currency (like the euro) and invest the proceeds in a higher-yielding asset, such as the Australian dollar.

Some believe that the European Central Bank will eventually be forced to adopt quantitative easing (QE) as the only way of helping the region out of its debt crisis (the recent provision of three-year liquidity to the banks is a step along that road). It is hard to be sure whether such a move would be bullish or bearish for the currency. The conventional assumption is that creating more currency is bad for its value: QE in America is generally agreed to have been negative for the dollar. But if QE is perceived to stabilise the European economy, it could end up being positive for the euro, at least in the short term.

As far as European economies are concerned a moderate decline in the euro would probably be good news, as it would deliver a modest stimulus at a time of turmoil. Few want to see the euro regain the heights of $1.60 reached in 2008.

The big risk, of course, is of a break-up of the euro zone, with Greece being the obvious candidate to depart first. The potential for contagion in the other peripheral economies means that such a move would almost certainly precipitate a wider banking crisis. Although the euro might still survive in the core countries like Germany and the Netherlands, Mansoor Mohi-uddin at UBS is surely right when he says that “the prospect of a stronger euro shorn of its weakest links would take years to materialise.” A break-up would turn a decline into a rout.

Date: 2014-12-29; view: 972