The European Union (EU) constitution was dealt a double blow, first by
a French “no" vote on 29-May and then by a follow on “no" from the
Netherlands on 01-Jun. To add insult to injury, one low level
Italian diplomat quickly called for a referendum in Italy to decide if
a return to the lira was warranted. Additionally, Prime Minister
Tony Blair, who took over leadership of the EU on 01-Jul, indefinitely
postponed the British referendum on the EU constitution.
This news along with plenty of speculation about the repercussions
dominated the international headlines for much of the month of
June. Not surprisingly, all the hubbub about the EU had a direct
impact on the FX market. The euro fell to a new seven month low
following the French referendum, reaching a low of 1.2371 and the
“single currency" has been under pressure ever since. Probes
below the 1.2000 level were seen ahead of 30-Jun, suggesting additional
near term downside potential toward 1.1756 and beyond.
Since the inception of the euro in 1999 central banks, especially those
in Asia and the Middle East were seen diversifying out of dollars into
the euro. They were not only looking to scale back their
substantial dollar holdings in the face of a declining market, but they
also sought the higher returns available in the eurozone.
However, returns on eurozone deposits slipped below those in the United
States in December and the FED’s string of rate hikes bodes well for
those differentials to further widen. Combine the better returns
in the US and a generally more favorable dollar outlook with the
specter of continued political turmoil within the EU and it seems there
is little incentive to hold euros at this point.
Truth be told, the EU was facing some rather significant hurdles long
before the double “noes" derailed confidence. Many of these
hurdles are associated with expansion. Discontent on the part of
established club members with the admission of central European
countries in May-04 and general hostilities about the proposed
admittance of Turkey played significant roles in the recent
referendums. In addition, diverging economic performance,
productivity growth, inflation and fiscal performance among member
nations are all fodder for further turmoil.
Worthy of particular note is the broad based economic malaise in
Italy. Italian consumer product manufacturers are losing their
battle with Asia and consequently the trade balance is moving into the
red. Unemployment is up, as is the budget deficit. Being
part of the euro, and therefore having a relatively high exchange rate,
essentially thwarts any effort to compete with Asia on price.
Without its own currency, Italy is unable to devalue out of its
non-competitive position. Hence, the aforementioned comments by
Italian Minister Maroni. Countries such as Portugal and Greece
are also in rather dismal economic health. The budget deficit of
the former has already reached 7% of GDP.
Many have noted that the EU constitution may be dead, but it’s not
buried yet. I’m not so sure that I would agree as approval of all
25 member counties is needed for ratification. The initial
thought was that any dissent was likely to come from newer or smaller
EU countries and that a little economic arm twisting by the likes of
France and the Netherlands might encourage them to reconsider.
Unquestionably the long standing skepticism of the Brits was going to
be an issue. However, rejection of the constitution by two of the
founding members of the EU certainly throws a wrench in the works.
I don’t believe that we need to worry about the European Monetary Union
(EMU) breaking up any time soon. In other words, the euro will
continue to be actively traded on the global spot market. A
Reuters poll early in June suggested there is only a 5% chance of an
EMU collapse within the next 15 years. However, around the same
time the German weekly magazine Stern reported that the failure of the
EMU was discussed at a meeting attended by German Finance Minister Hans
Eichel and Bundesbank President Axel Weber. Having said that, I
don’t think there is any question that there is a greater risk premium
attached to the euro than there was a month ago.
In the months ahead, look for continued political wrangling within the
EU. Further bad news is likely to be forthcoming, which should
help keep the euro under pressure, creating trading opportunities not
only against the dollar, but in the cross rates as well.
Peter Grant is VP of Operations for CFS Capital Management
(
www.cfscap.com), offering managed forex trading accounts. Read the
entire newsletter online at
www.cfscap.com/news.htm
