The euro has had a good couple of weeks.
Against the dollar, the single currency has gone from below $1.30 earlier this month, to above $1.36 now.
This is despite political turmoil in Ireland, on top of all the usual concerns about the eurozone’s lack of a specific plan for getting them all out of the current mess.
So what’s been driving this strength? And can it last?
Europe is in demand
Investors are keen to buy into bonds issued by the European Financial Stability Facility, according to the FT. One banker told the paper: “Investors love these bonds because they offer the safety of a triple-A credit, while at the same time they provide a bit of extra yield over German bunds.”
Hmm. Where have we heard that attitude before? “Gosh, these sub-prime mortgage-backed bonds are great – the credit rating agencies say they’re AAA, and yet you get a bigger yield than on a Treasury. What could possibly go wrong?” You’d think these guys would have twigged by now that there’s no such thing as a free lunch.
Before the eurozone blew up, investors were happy to buy Greek debt at German prices, assuming it was backed by Europe’s strongest economy. That wasn’t entirely correct. Now they’re doing the same again – buying debt that’s merely part-backed by Germany and acting as if it’s in effect a German government bond.
But how that all unravels is a threat for the longer term. For now it seems that the market is optimistic again on Europe’s prospects. A couple of Spanish companies – telecoms group Telefonica and utility provider Iberdrola – managed to get bond issues away yesterday too.
Why the change of heart? Partly it’s because investors hope that Europe can pull together and expand the bail-out fund if needed. Portugal’s recent election didn’t result in any surprises. And even the upheaval in Ireland isn’t worrying the market, because most of the parties involved have agreed to back the crucial Finance Bill to make sure it’s passed before the general election.
Why the big concerns are now in the US
But it’s also partly because focus has switched from concerns about European solvency to fears about the solvency of US cities and states. Money has been steadily flowing out of the ‘muni’ bond market. Indeed, last week saw investors pull the largest amount on record from the sector – $3.5bn. US states and cities issue ‘muni’ bonds to raise money to fund public spending and infrastructure building.
Several cities – not to mention states such as Illinois and California – are hugely indebted. We already knew that. What’s new to the picture is the threat of a change in US law that would allow states to file for bankruptcy. This would enable them to restructure their debts and also give them leverage in dealing with unionised workforces (not unlike big corporations who file for bankruptcy protection). But clearly it adds to the risks of buying munis.
Meanwhile, the Federal Reserve has been quite keen to argue that it won’t step in to save any bankrupt states. Encouraging moral hazard in the banking sector is one thing – doing the same in the public sector is quite another, it seems.
The muni market is a complicated one, with lots of different issuers and different types of debt. And it’s hard to see exactly how much of a risk it poses. Meredith Whitney – the US analyst who made a name for herself predicting the collapse of the banks in 2007 – has warned of hundreds of billions of losses. But many other analysts are more sceptical. The worst year ever for muni defaults was 2008 – and losses added up to around $8.2bn, according to Joe Mysak on Bloomberg. That doesn’t mean Whitney is wrong. But the collapse would have to be pretty spectacular.
And just like Europe, much of the eventual outcome depends on political decisions rather than economic ones. Will the European Central Bank continue to bail out troubled eurozone countries? Will the Fed – if push comes to shove – save a bankrupt state? It’s what the market believes on any given day about the answers to these questions that will dictate the direction of things like the exchange rate, for example.
So how on earth do you trade such a volatile situation?
If you want to play shifts in the currency markets, you need to get a handle on what drives the market. And I think our spread betting blogger, John Burford, is a good man to listen to on that score. I know that a lot of investors are sceptical about technical analysis. But while you can base long-term investments on fundamentals – and that’s my preference – if you’re trading on a day-to-day basis, the long-term outlook really won’t help you turn a profit.
It can take a long time for the markets to turn to your way of looking at things, if they ever do. And with high-risk activities such as spread betting, for example, you don’t really have the luxury of time. So if you’re interested in trading currencies (or any other big market for that matter) I’d suggest signing up for John’s free email, MoneyWeek Trader. His strategies for profiting from spread betting are aimed at traders, but I think anyone will benefit from his insight into how the market works on a day-to-day basis.
• MoneyWeek Trader is an unregulated product published by MoneyWeek Ltd.
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