Central banks throw the euro a life raft … how you can profit

My son, JR, has filled in for me on a few occasions. He is also co-editor of my World Currency Trader service. Today he has an interesting insight regarding the euro and how to play it. And I think you could find it profitable. — Jack

I wrote this in Money and Markets on January 14 regarding my outlook for the euro:

“Its only saving grace would be a rising tide of risk appetite.”

My idea that the euro would rally was based on its sell-off being a bit overextended and expectations it (and other assets) would play catch up to stocks. So far that has worked according to plan …

The euro has risen 3.8 percent against the dollar since January 14 — a rather large move if you’re playing the forex market. But technical and sentiment reasons are not all that’s moving the euro now.

A focus on money printing and central bank policy has become a life raft for pushing the euro higher. And that is going to continue — not only because the European Central Bank is working overtime to save the euro zone, but because its counterparts are also complicit in this game to keep interest rates down and credit lines open.

Let’s go over the four main players, starting with the …

European Central Bank

For the better part of 2011, while we were blitzed by pie-in-the-sky bailout packages and financing operations for the euro zone, the ECB spoke tough. For it was not the job of the ECB to purchase sovereign debt; it was the job of banks within those sovereign nations.

Now that we’ve wasted a year watching policymakers produce insufficiently funded lending facilities (e.g. ESM, EFSF, LTRO), euro-zone banks are cutting lending and shoring up their own finances.

The ECB has an overly-leveraged balance sheet and is thus far refusing poor collateral in exchange for loans (or so they want us to believe). Not exactly a functional system if there ever were one.

Last month the ECB chose not to cut interest rates. We’ve speculated as to why (a wait-and-see approach). But the ECB is expected to take that step in March, assuming they don’t surprise with a rate cut next week. They have plenty of ground to give in hopes of supporting the banking system and, thus, sovereign debt.

And let’s not forget about currency swaps with the Federal Reserve — the ECB is becoming quite reliant on that arrangement lately to help alleviate their liquidity problems.

Not since 2009 when central banks were responding to the credit crunch were outstanding swaps this high. When it comes down to it, the ECB will eventually become the local backstopper of last resort when nothing else succeeds in alleviating the pressure on banks and sovereign debt. And they sure won’t mind assistance from the Fed.

The Federal Reserve

You may have heard the latest from the Federal Reserve — the FOMC’s extended period of low interest rates has been extended by another year and a half (out to the end of 2014 now).

Ben Bernanke, in testimony to the House Budget Committee on Thursday, said,

“Risks remain that developments in Europe or elsewhere may unfold unfavorably and could worsen economic prospects here at home.”

Hardly newsworthy …

But perhaps he had to say it to prove he’s not out of touch. What he is probably more comfortable with is the pledge to help the U.S. avoid the fallout from a major collapse in the euro-zone financial system.

It’s tough to say when the euro zone will break. It could happen when Greece defaults, which seems fast-approaching. Euro-zone officials are doing everything they can to avoid contagion from a Greece default, but it is unlikely they’ll be able to fully deflect the pressure on other sovereign nations.

This may be the catalyst for the Federal Reserve’s third round of quantitative easing. Many expect the arrival of QE3 is not a matter of if … but when.

At this point, the Fed pledges low interest rates and additional forms of easing to improving the economy. But the Fed knows full well its efforts have not had a direct effect on improving the U.S. economy. They are thus resigning themselves to propping up asset prices, but they aren’t fixing anything except the price of money.

Bank of England

The UK economy is set to enter a technical recession of at least two consecutive quarters of contraction. The Bank of England (BOE) has acknowledged the softness in the UK economy and has telegraphed the advent of additional quantitative easing.

Next week, when the BOE announces its latest policy decision, it is expected they will unleash an additional £50 billion. Pessimistic expectations for the British pound and UK markets have been somewhat muted because the government has imposed austerity measures aimed at shoring up the budget. Those measures consist of increased taxes and spending cuts.

Roughly 75 percent of the tax hikes have been implemented and are loosely blamed for the current and coming economic soft patch. But very few of the austerity plan’s spending cuts have been made, which suggests the expected recession could last longer if the cuts are implemented.

To sum it up: The government’s commitment to austerity suggests the BOE will remain the sole life raft helping to buoy investor sentiment in the UK.

The People’s Bank of China

The People’s Bank of China (PBC) is wrapped up with its own economic management efforts. When growth is on the fritz, China eases up on interest rates and reserve requirements; when inflation is on the upswing, China clamps down on easy credit in hopes of stemming overinvestment.

Unfortunately, it is too late to stop malinvestments. And the PBC must now resort to volatile methods of managing the peaks and troughs of inflation and growth. This means encouraging lending and investment through government conduits. Or it means slamming on the brakes to avoid extreme price pressures on its people.

It also means doing its share to keep the current global system operational because they can’t yet survive without external demand for their exports. And that might mean propping up Europe.

China recognizes the contagion potential in the euro zone; and they’re scared of it. At times they’ve suggested they’d provide funds to help backstop European sovereign debt. This week was another one of those times.

Though it might only be lip-service because the PBC may be a little more strapped than one might imagine, as the following chart suggests.

We’re at a point when central banks continue to push investors towards riskier opportunities by making fixed income unappealing with abnormally low interest rates. That explains why markets rise with new and substantial initiatives from central banks. But this dynamic could come to an end, even if quantitative easing continues.

Perhaps this next chart will help. It shows how the combined size of eight central banks’ balance sheets has almost tripled in the last six years from $5.42 trillion to more than $15 trillion and is still on the rise!

Recently, the eight central bank balance sheets have spiked back to 33 percent of world stock market capitalization. This has come about not by lender of last resort loans, but rather by QE expansion (buying bonds with printed money) even faster than world stock markets are rising.

Credit to the real economy is tightening up around the globe. And though central banks are committed to the hope of propping up economic data with money printing and credit pumping, we expect deleveraging to eventually overwhelm the marginal impact of credit-creation efforts in 2012.

Balance sheets among central banks are becoming ridiculously swollen. It’s not clear how much more time they can buy before economies must start showing improvement. The Fed may be smart to hold off on QE3 for as long as possible. Because once they employ it, if it doesn’t have a tangible impact on the real economy, investors may finally lose their patience.

What to Do …

With the central banks moving decisively farther down their preferred path of low interest rates and easy money, risk assets should go up. And if you’re a currency investor, that means the euro should be stronger versus the dollar as long as the ECB and central banks succeed in warding off the risk of sovereign debt contagion.

Right now they are succeeding; but their plan is extremely vulnerable to disruption. Stay tuned.

Best wishes,

JR

P.S. Investing in currencies is as easy as buying a share of IBM. And to help you, I’ve put together my Currencies Made Easy video library — a $995 value — that I’ll send to absolutely FREE just for giving my World Currency Trader service a try.