Greek Debt Weighs On the Euro

The dollar rained on the currencies’ parade on Friday, as a lack of data and interest rate increase in India chased investors back into the greenback. The passage of healthcare reform by the House is dominating the news wires this morning, so I will have to try and figure out what that will mean for the currency markets. But I will begin in Europe…

The weekend didn’t bring any resolution to the Greek problem, and the EU is heading back behind closed doors to try and figure out what they will do. German Chancellor Angela Merkel continues to dampen any expectations of an agreement for an aid package. Both Greek Prime Minister George Papandreou and European Commission President Jose Barroso said the EU should spell out its rescue plan at this week’s EU summit in Brussels. But Ms. Merkel said in an interview this weekend that the EU must not create ‘illusions’ for markets by building expectations of Greek aid.

It is clear that Merkel is going to keep the EU members honest, and not let them use ‘jawboning’ to paper over the Greek debt problem. Her comments will keep a lid on the euro (EUR), and may even push it lower. Standard Bank PLC believes the euro will move dramatically lower in the coming weeks. “It is a key week for Greece and the EU, which leaves euro-dollar staring over the precipice of a slide to $1.25,” Steve Barrow, head of currency strategy at Standard Bank wrote in a report today. “A $1.25 rate still beckons and it could come quite soon.”

The pound sterling (GBP) sold off a bit versus the US dollar on Friday, and is by far the worst performing currency for 2010. The pound has lost 7.25% of its value versus the US dollar since the beginning of the year, and with elections on the horizon; there just doesn’t seem like there will be anything to change the direction of UK’s currency. According to a report was released this morning by the Confederation of British Industry, the UK’s recovery will be ‘slow and sluggish’. This gives the BOE more reason to extend their ‘quantitative easing’ programs and to keep interest rates low.

The item dominating the news wires this morning is the passage of health care legislation yesterday by the House of Representatives. The House passed the Senate bill, but also passed a bill with some changes that will go back to the Senate for their approval. This use of ‘reconciliation’ was seen as the only way congress was going to be able to shove this through, and was a major victory for President Obama.

Chuck has warned me against writing too much about the health care reform, as it stirs up a lot of passion from both sides. From what I have read of the new reforms, there is a lot I agree with, and probably just as much that I don’t. The biggest question I have is how we are going to pay for the improved coverage of the uninsured. I have heard some claim that the bill is ‘deficit neutral’; but I have a very hard time believing this. Some have said that the improved coverage will be paid for with ‘elimination of waste’ in the current system. I sure hope this is true, but my question is why haven’t we eliminated this waste already? Does anyone truly believe that our government is going to be much more efficient running healthcare than they have been running the post office, or Social Security?

Congress just continues to spend money we don’t have, and this is not good for the long-term value of the dollar. The government will need to finance these new programs, and will again turn to the debt markets. By increasing our immediate financing needs, the new legislation will cause us to have to issue more debt. Adding more issues to an already crowded US treasury auction will naturally lead to lower prices for the debt and higher interest rates here in the US. It is a vicious cycle, as these higher interest rates cause us to have to pay a larger percentage of our revenues to cover the interest, which in turn takes more money out of our spending programs. So by running higher deficits, we are all but guaranteeing we will have less money to fund all of these programs. More and more of our revenues will be going toward interest on our debt, and directly into the pockets of those countries that hold it. It may be overly simplistic, but any program that increases our long-term deficits is bad for the US, no matter what the short-term benefits are. We have got to get a handle on our deficit spending or else the dollar will fall dramatically.

But right now, investors continue to see the dollar as a safe haven, and enjoyed a spurt of safe haven buying on Friday. A move by the Reserve Bank of India to increase borrowing costs on Friday caused investors to exit risk positions and move back to the US dollar. Many were surprised by this latest move higher, but Chuck and I have written about higher inflation in India for some time. Inflation hit a 16-month high and has exceeded the rate in all other G20 economies, so the Reserve Bank wanted to take action saying curbing inflation had become ‘imperative’. And the news accompanying the increase suggests the next move may come as soon as next month.

The ‘surprise’ move by India sent a shiver through currency investors as they predict the higher rates will cause a economic slowdown. But wait, isn’t this exactly what higher rates are supposed to do? Well currency investors, especially those buying emerging market currencies, like high growth rates. The increase in interest rates that is meant to cool inflation is seen as a threat to these double-digit growth rates. And these investors also believe that if India is increasing rates, other emerging markets like China and Brazil will soon be following suit. Currency investors moved away from these currencies and back into the ‘safety’ of US Treasuries on Friday.

All of the high-yielding currencies lost ground versus the US dollar on Friday, with both the New Zealand and Australian dollar moving lower. Commodities were down, with both gold and oil selling off a bit. The markets have taken on a cautious feeling with questions over the Greek rescue and inflation concerns in the emerging markets. Investors, not wanting to take on additional risks, have parked their funds into the US dollar in order to wait to see what the future has in store.

Gold was fairly stable over the past week, and is also flat on a year-to-date basis. Gold continues to be pushed down by a rising US dollar, as their inverse relationship continues.

We won’t get any data to move the markets today, so I would expect more of the same for the US dollar. We get the latest on the housing market tomorrow with existing home sales for February along with the house price index and ABC Consumer Confidence numbers. The durable goods numbers will be released on Wednesday along with the new home sales data for February. Thursday will bring us the weekly jobs data and we will end out the week on Friday with and update of the fourth quarter GDP numbers.

Chris Gaffney
for The Daily Reckoning

The Daily Reckoning