The Rising Value of the Euro

I am trying real hard to stay away from discussing the ongoing Washington budget battle that appears on track to end in a government shutdown at the end of this week. The huge idealogical gap between the two sides makes the entire exercise little more than theatrics and political posturing. I am of the view that the market is sophisticated enough to see through the rhetorical fog.

I would rather focus my attention on developments across the pond, particularly the source of strength in the common currency in the face of so many problems in Europe’s backyard.

The exchange value of the European common currency has been moving in one direction only in recent days — up. The Euro has effectively gone back to the start of 2010, before debt problems in the peripheral European countries became center stage.

The primary reason for this strength is the expected tightening from the European Central Bank (ECB). As I mentioned yesterday, the ECB’s response to the recent surge in commodity prices is to raise interest rates. This puts the ECB on a completely different track from the U.S. Fed. As we saw yesterday’s minutes of the Fed’s last meeting, the U.S. central bank does not appear to be too concerned about the inflation picture.

Part of the reason for the divergence is the Fed’s dual mandate; it is not only required to control inflation, but to also ensure full employment. And the employment picture, while improving, is far from satisfactory. The ECB, on the other hand, is only required to fight inflation.

It appears premature for the ECB to start raising rates at this stage, particularly given the woes of the peripheral countries. They seem to have given up on Greece, Ireland, and Portugal. But it is far from certain at this stage, as the ECB’s expected rate hike would imply, that the problems would not engulf Spain.

The die appears to be cast for a Portuguese bailout, most likely to take place following its June parliamentary election. The country’s rising borrowing costs, as highlighted by today’s T-Bill auction, make it all but certain. They paid an average yield of 5.9% on the 12-month T-bills, up from the 4.3% level of early March. Even Portuguese commercial banks are getting wary of their government’s paper given the deteriorating credit ratings.

All of this is putting the spotlight on Spain, which is in an altogether different league than the earlier bailout recepients. Spain has initiated a tough austerity program and is working hard to address the problems in its regional savings banks. But it is far from certain at this stage that those actions would be enough to forestall a full-bore crisis.

The larger debate about the U.S. financial profile is not unrelated to what has been going on in Europe over the past year. But the debate needs to move beyond narrow ideological positions to make it more serious.

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