If you’re planning to bet on the foreign exchange markets, interest rates are one of the most important things to watch.
By and large, if the central bank that issues the currency is raising rates, that’ll make the currency stronger. Just like with a bank account, the higher the interest rate you can get, the more attractive the currency.
Yesterday, the European Central Bank (ECB) signalled that it would raise interest rates next month.
In fact, of the world’s four biggest currencies (the US dollar, the euro, sterling and the Japanese yen), the euro is the only one currently backed by rising interest rates.
And yet, the euro tanked.
Why?
Germany and the European Central Bank square up over Greece
ECB president Jean-Claude Trichet said that the ECB will exercise “strong vigilance” over eurozone prices yesterday. That’s a transparent code phrase which means “we’re going to raise interest rates next month”. Why they don’t just say that is anyone’s guess.
But in any case, it’s exactly what the market had expected. What rattled investors however, was the obvious fact that the ECB and Germany still don’t agree on how to bail out Greece.
Here’s the problem. Germany wants the private sector to contribute to the costs of a Greek bail-out. In other words, private investors in Greek debt shouldn’t be given a free pass. They should have to take a haircut along with the taxpayer.
German finance minister Wolfgang Schauble suggests that a good bet would be for existing holders of Greek debt to ‘volunteer’ to swap their current bonds for ones that extend the payback period by seven years. So it’ll take a lot longer for lenders to Greece to get their money back.
The ECB isn’t keen on that solution. It would rather that governments found a way of continuing to hand Greece money while the country cuts back and reforms its economy. In other words, the ECB would rather stick with ‘extend and pretend’, and effectively dump the costs on the international taxpayer.
One reason for the ECB’s objection to any restructuring is that the ECB itself holds a lot of Greek debt. Indeed, Citigroup reckons that the ECB holds around a third of Greek government bonds held outside Greece. German and French banks account for another third between them.
The ECB doesn’t want to take a hit on that stuff, particularly as it wasn’t keen to buy it in the first place. If there’s a ‘voluntary’ debt rollover, the ECB won’t be taking part – Trichet said that “it is certainly not our intention” to roll over Greek debt holdings.
The bigger problem is that if there’s any sort of debt extension, it will probably be classed as a default. You’d then have the question over who held credit default swaps (CDS) on Greek debt. CDS are basically insurance against a bond defaulting, so the banks who wrote this insurance could be faced with a hefty bill.
In short, whatever the solution to Greece’s problems turns out to be, it will be messy.
That’s not to say that Greece alone could destroy the euro. As Gary Jenkins at Evolution Securities puts it, “it is unlikely that anyone in Europe wants to undertake a Lehmans-like experiment with an EU sovereign.” There is “a big difference between a controlled default managed by the EU/ECB/IMF at a time of their choosing, and an uncontrolled default which would have huge implications for the likes of Irish and Portuguese bonds.”
So you would think that they’d try to hammer out a solution between them.
What does this mean for investors?
However, in the meantime, this stalemate is bad news for the single currency.
The promise of rising rates has been the main thing propping up the euro this year. But now it looks as though the rate hikes are set to stop.
And without that prop, investors will start to focus on the Greek problem. The longer it drags on for, the less confident markets will become that a solution can be found.
Meanwhile, if the US manages to get its wrangling over the deficit sorted out, and quantitative easing part three doesn’t appear, we could see a hefty dollar rally over the next six months.
I still prefer the Aussie dollar as a short for now. Politics is less of an issue there, and with Chinese demand apparently weakening, the fundamentals for the Aussie look fragile.
However, if you’ve been looking for opportunities to short the euro, the next few months look set to be very turbulent for the single currency. So if you are interested in taking advantage, then you should sign up for John C Burford’s free MoneyWeek Trader email now. It’ll give you tips and strategies on how to make the most of your spread betting profits and how to cut your losses short.
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