Greek Crisis May Provoke Fed-ECB Split as Euro Slides (Update1)

By Simon Kennedy
March 23 (Bloomberg) -- European Central Bank President Jean-Claude Trichet’s campaign for governments to learn the lessons of the Greek fiscal crisis may provoke a transatlantic policy split that forces the euro back toward its lows of 2006.
As investors push Greece, Spain, Portugal and Ireland to deliver on plans to cut budget deficits, the withdrawal of stimulus raises the risk of double-dip recession and even deflation in all or parts of the 16-nation euro area. The possibility of slower expansion is prompting economists from Deutsche Bank AG to HSBC Holdings Plc to predict Trichet’s ECB will be slower than they previously anticipated in raising its key interest rate from a record low of 1 percent.
Trichet’s restraint would contrast with Federal Reserve Chairman Ben S. Bernanke if the U.S. central banker takes the lead in tightening economic policy while lawmakers show few signs of attacking a budget gap of more than 10 percent of gross domestic product. Such different approaches across the world’s biggest economies has BlueGold Capital Management LLP predicting the euro will fall to $1.20 for the first time since March 2006, echoing a decline when the Fed last outpaced the ECB in the middle of the last decade.
"This policy divergence is one of the central pillars of my view going forward," said Stephen Jen, managing director of hedge-fund manager BlueGold in London and a former chief currency strategist at Morgan Stanley. "It is one more reason for investors to be cautious about the euro."

Contrasting Policies

Europe’s single currency fell 0.3 percent to $1.3515 at 8:50 a.m. in London today, taking its decline in the past four months to 10 percent, amid speculation European Union leaders will fail to agree on an aid package for Greece this week.
When the Fed last began raising interest rates, from 1 percent in June 2004, it overtook the ECB’s benchmark 2 percent by December and had increased the overnight lending rate between banks another seven times before the Frankfurt-based ECB first shifted its benchmark in the final month of 2005. That helped push the euro down 13 percent against the dollar in 2005, when it traded as low as $1.164 that November after three years of gains.
"We’re shorting the euro," said Stuart Thomson, a fund manager at Ignis Asset Management in Glasgow, which manages the equivalent of about $107 billion. "It’s impossible to see the ECB raising rates anytime soon in the current environment and certainly not before the Fed."

Holding Pattern

Part of the reason for the ECB’s holding pattern is the growing likelihood of fiscal retrenchment. Governments have violated the EU’s deficit limit of 3 percent of gross domestic product for a third of the euro’s first decade. Now the turmoil in Greece is forcing them to consider greater fiscal discipline after investors more than doubled the risk premium they demand on Greek 10-year bonds over their German equivalents amid its struggles to cut a 12.7 percent budget gap, the most in the euro zone.
Greece has passed three packages of deficit-reduction measures this year, including cuts totaling 4.8 billion euros
($6.5 billion) announced March 3, in a bid to lop four percentage points off its budget gap this year. The spread between yields on 10-year Greek and German bonds jumped to as high as 396 basis points in January from as low as 132 basis points in November. The gap was 326 basis points today.

‘Unusual Fiscal Discipline’

Other countries are seeking to avoid Greece’s fate, with most pledging to satisfy the EU’s deficit rule by 2013 at the latest after the European Commission estimated the euro area’s overall gap jumped to 6.4 percent last year from 2 percent in 2008. It predicts an increase to 6.9 percent in 2010.
Spain is enacting 50 billion euros of cuts and has proposed raising the retirement age two years to 67 to pare a 10.1 percent gap, while Portugal is planning 6 billion euros of measures including asset sales to reduce an 8 percent deficit.
Ireland has won plaudits for its plan to shrink an 11.7 percent shortfall by reducing public workers’ wages and some welfare payments.
"Events in Greece could trigger unusual fiscal discipline in the euro area, implying tighter policy than expected," said Laurence Boone, chief French economist at Barclays Capital in Paris, who estimates the euro-area deficit will fall to 5.8 percent of GDP next year, compared with the European Commission’s 6.5 percent estimate in November.

Reduced Forecast

Such discipline may go some way toward appeasing Trichet.
He has called deficits a "potential burden" on monetary policy and said in a March 12 Bloomberg Radio interview that governments must act "with utmost energy" to convince investors they can restore sustainability.
Their budget cuts "could add further gloom to growth prospects in the near future but also plead for long-lasting accommodative monetary policy," Boone said, predicting the ECB will keep its key rate unchanged this year.
Deutsche Bank economists last month cut their forecast to show the ECB raising its benchmark interest rate by 50 basis points in the final quarter, half what they previously predicted. Their counterparts at HSBC said yesterday they now expect the central bank to stay on hold until March 2011 rather than shift before the end of this year.
At Morgan Stanley, Chief European Economist Elga Bartsch in London is less convinced that tougher fiscal policy will be the reason the ECB waits. She argues the region’s largest economies have yet to detail how they will cut back and estimates the bloc will tighten fiscal policy by just 0.7 percentage point of GDP next year, short of the 0.9 percentage point she calculates is required to fulfill the EU targets.

Stalled Economy

The euro-area economy nearly stalled in the fourth quarter, when it grew 0.1 percent from the prior three months. It will require the support of easy monetary policy if governments carry out their promise to reverse stimulus, said Jennifer McKeown, an economist at Capital Economics Ltd. in London.
While euro-area industrial production surged the most in two decades in January, unemployment held at an 11-year high of
9.9 percent and retail sales fell 0.3 percent from December.
Even if the broader economy escapes renewed recession, individual members may not be so lucky, McKeown said. Greece and Spain continued to contract 0.8 percent and 0.1 percent respectively through the fourth quarter, while Portugal shrank by 0.2 percent after expanding 0.7 percent in the previous three months. Deflation also still poses a "real risk" to the euro area, especially in Spain, Ireland and other nations that suffered when property bubbles burst, she said.

Disaster?

"The ECB will need to keep rates very low for a long time if governments tighten," McKeown said. "If it doesn’t, it will be disastrous for some economies."
The outlook may differ in the U.S., with the Fed proving faster than the ECB to raise rates, said Michala Marcussen, head of global economics at Societe Generale SA’s investment-banking division.
She expects the U.S. central bank will begin lifting its near-zero benchmark rate around the end of this year, increasing it to 1.25 percent in 12 months. The ECB’s main rate will still be 1 percent in a year, she said, helping to push the euro to $1.25.
"We see the U.S. leading on monetary-policy tightening,"
Marcussen said.
President Barack Obama’s administration is projecting a budget deficit of 10.6 percent this year and 8.3 percent next year. Even five years from now, the White House forecasts a budget gap of just below 4 percent of GDP.

‘Enormous Deficits’

Limiting progress this year are mid-term congressional elections, making it unlikely lawmakers will ask voters to pay higher taxes or accept cuts in government programs. A budget commission Obama appointed also isn’t due to release its recommendations until after the November balloting.
"If we do have substantial fiscal tightening, that could mean lower interest rates both at the short end and the long end," Harvard University Professor Martin Feldstein said in a March 13 interview. "I wish I saw that happening in the U.S. At this point we’re still looking at these enormous deficits."
A further decline in the euro will be welcome relief for the European economy by boosting exports, said David Owen, chief European economist at Jeffries Group Inc. in London. A 6 percent drop so far this year in the currency has already handed manufacturers from printing-press maker Koenig & Bauer AG in Wuerzburg, Germany, to French carmaker Renault SA an edge to sell their products in international markets.
"The euro system desperately needs a weak euro," Owen said.
The current crisis also may ultimately spur European officials to toughen their oversight of government policies, resulting in smaller imbalances and a stronger currency union that supports the euro, BlueGold’s Jen said.
"Greece is just the right size to reveal flaws in the system and ensure they’re addressed," Jen said. "It may be a blessing in disguise."

Tighter Monetary Policy by the Fed and ECB is inevitable. The system needs to drain most of its excess/artificial liquidity. However, I do not think a lack of near-term Monetary Policy tightening by the ECB will have a great impact on the EUR/USD pairing. I am more certain this stance will have a greater impact on the spread between the yields on German Bunds vs. US Treasuries.

A consistently high fiscal deficit sends warning shocks to the pair more so than monetary policy shifts. I also see QE as a more important indicator of economic strength as well. How much longer do the EU or US need copious stimulus measures?