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Market is overreacting

May 17th, 2010 · No Comments

The stories about Europe’s demise are highly overblown…

Yes, the cavalry left it late, as usual, but they came full force. The combined efforts of the EU, IMF, and ECB have saved the euro area from its own ‘Lehman moment,’ which was days, perhaps even hours away.

A ‘Leman moment’ is when the interbank market freezes up because banks don’t trust each other’s books, due to their exposure to toxic debt. In this case, sovereign debt, mostly of the so called ‘PIIGS’ (Portugal, Ireland, Italy, Greece, Spain).

The quantitative easing of the ECB especially saved the day. It is now quietly removing these toxic assets from banks balance sheets, thereby taking much the sting out of a possible default (Greece still seems inexorably on its way, in our view).

That was the good news. Now, the markets are focusing on the quid-pro-quo of the rescue package, forcing economies to severe austerity measures. The danger is that it might endanger economic growth in Europe.

That is indeed something of a risk, a risk which we have noted before. However, the quantitative easing of the ECB should produce effect, like it has in the US. If we’re lucky, it should also provide a modicum of inflation which reduces the real value of those debts, and allows those euro area countries that can’t devalue to restore their competitiveness vis-a-vis the rest of the euro area to have less inflation than their trading partners so restoring competitiveness in that way.

And, now currency markets coming to the rescue, adjusting in a way that is highly favourable for the world economy:

  • US economic growth has surprised on the upside, so the strengthening of the dollar isn’t that much of a disaster
  • The US is benefiting from the euro areas woes in another way as investors run for savety, reducing US long-term interest rates in the process
  • But the fall of the euro should really cushion the coming European austerity
  • And the US might get another shot in the arm when the Chinese revalue the yuan.

So we although we think the situation is bad, it’s not that bad. Europe did what it had to do. Yes, economic growth there might very well take a hit, but economies could easily emerge stronger if they’re also embarking on the necessary structural reforms. And most importantly, the ECB is playing ball, which one can really see in the currency and gold markets already.

Tags: Sovereign debt crisis