As the situation with respect to Greece developed in recent days, the euro fluctuated within a surprisingly narrow range versus the US dollar. During the second quarter, the euro actually strengthened as prospects for avoiding a Greek default deteriorated. It appears the final act for Greece is about to be played. By the end of this weekend we should learn whether Greece and its creditors are able to come to an agreement on a bailout that permits Greece to avoid defaulting on its international debt repayments and provides needed additional liquidity to Greek banks — or whether, having failed to reach an agreement, Greece is headed for default, the collapse of its banking system, and exit from the euro as its currency, at least for a “temporary” period, which could become permanent.
While the chances for a negative outcome this weekend surely have increased, the market still appears to expect that an agreement finally will be achieved. If an agreement comes to pass, the immediate reaction of the euro will likely be to strengthen versus the US dollar, but only modestly, since such an outcome is largely priced in. However, should the attempts to conclude an agreement fail, the negative currency market reaction could be strong, for three reasons: such an outcome has not been priced in; the euro would likely be viewed as a more fragile currency subject to the possibility that other (and larger) heavily indebted countries will eventually leave the currency; and, most importantly, the prospect that the European Central Bank ECB) would have to increase its quantitative easing as it seeks to avoid contagion across the rest of the Eurozone.
In the medium and longer term, Greece will cease to be an important factor for financial markets. Even in the case of “Grexit,” the effects are likely to be successfully ring-fenced. The divergence in monetary policy between the US and Europe will return as the dominant factor. The US Federal Reserve will be in the process of moving away from its extraordinary monetary easing, starting to raise its policy rates, possibly as early as September and no later than early 2016. The ECB, on the other hand, is scheduled to continue its very substantial asset purchase program through September 2016 and very likely will continue it beyond that date. Further factors that will contribute to the continuation of the bull market for the US dollar versus the euro will be the relatively stronger US banking system and a more robust US economy.
The prospect of the euro’s further weakness versus the “greenback” may explain some developments in the first quarter of this year in the Currency Composition of Official Foreign Exchange Reserves (COFER) as tabulated by the International Monetary Fund (IMF). The individual-country components of this data, which have been gathered by the IMF since the 1960s, are confidential. It was not until 2005 that the publication of quarterly aggregate COFER data began. The data currently include reports from some 147 entities, including those of all advanced countries, and amount to $6,063 billion, which is a little more than half of the estimated $11,433 billion global official reserves.
Reserve managers’ allocations to different currencies can be divided into active currency allocation decisions and passive changes due to valuation changes. The economists at Goldman Sachs do an excellent job of analyzing the quarterly COFER reports. They note that in the first quarter total allocated reserves in euros declined by $87 billion. They estimate that the decline in the euro during the quarter had a valuation effect of -$151 billion. This data point implies that reserve managers took action to offset only part of the negative valuation effect on the allocation to euros in their reserves. Their “active” decision was to let the valuation effect reduce the share of reserves that is in euros. Such changes are likely to continue if, as we expect, actual and projected rate differentials favor the US dollar.
In our International and Global Portfolios we are continuing to use, where available, ETFs that are hedged against continued strengthening of the US dollar.
Related podcast interview:
Kim Wallace: Greece Unlikely to Exit – There Is No Alternative to Europe
