Around the Globe 11.04.2013

Janet Yellen’s mission impossible—Commentary.

Could QE spur deflation, not inflation?.

There are two reasons why the Fed will keep printing. 1st:

Fed Balance Sheet vs. SP500 10.2013

2nd:

US 10yr through 11.04.2013

The creation of the 401(k) years ago politicized the stock market.  The government’s policy of herding Americans into purchasing equities to fund their retirements has created an expectation that the government must do something about falling markets, so it does.  Additionally, the government must be able to finance itself.  A rise in treasury rates would result in higher deficits down the road; hence, the Fed must keep rates low and the only method currently at its disposal is the printing press, so print it does.

Ultimately, all of this printing is slowly destroying the economy, because QE is ultimately both inflationary raising assets prices and deflationary suppressing income growth.  Japan started its own money printing program in the late 90’s, and you can see for yourself how incomes are performing:

Japanese Incomes

Like the Fed, ECB expected to keep on pumping.

ECB may soon join the flight of the doves | Reuters.

Debt crisis has left Germany vulnerable – FT.com.

USDEUR Exchange Rate vs Fed to ECB Balance Sheet Ratio

The MFP and its assorted shills, hangers on and supplicants believe that the ECB will begin printing in earnest to match pace with the Fed, and it just might but not for the reasons it endlessly touts: unemployment, lower inflation and economic contraction and stagnation in the periphery.  Rather, the only thing you need to know is the USDEUR exchange rate.  When it rises to a level that threatens Germany’s export machine, then there will be an ECB rate cut and not one second before.

The chart above illustrates the relationship between the dollar/euro exchange rate and the Fed/ECB balance sheet ratio.  As you can see, the rate has diverged from its long-term relationship, but these divergences are only temporary.  The euro will continue it general, upward trend for the near future.  Once the euro crosses the $1.45 line, the ECB will consider a rate cut because this is the rate that curtails Germany exports.

China reform checklist: How to tell that this time it’s for real? | Reuters.

China 7 Day Repurchase Rate 11.04.2013

 

Chinese leaders enjoy discussing economic reforms almost as much as the mainstream financial press hyping said reforms.  Chinese leadership has linked economic growth with political stability.  In light of this fact, this is all you need to know about Chinese economic reforms: if the reforms have any negative consequences, they will quickly be rolled back.  The PBOC has been attempting to liberalize the financial system by stepping away and letting the banks fund each other rather than relying on central bank liqudity.  Unfortunately, whenever it begins backing out of the overnight lending market, interest rates spike, so it rushes right back in.

This is exactly how government reforms will proceed.  The government will attempt to reform the economy.  Once adverse consequences erupt, (i.e. higher unemployment, the wrong guy’s factory being shuttered) the government will reverse course in short order.  After conditions settle down, it will make another feeble attempt to reform and change its mind once the consequences return.  Rinse and repeat.

High unemployment? Blame high home ownership, study says – NBC News.com.

Unemployment versus Home Ownership

 

This is an interesting study.  High rates of home ownership lead to higher structural unemployment.  This study’s conclusion makes sense, and it survives a careful reading.  Renters are more mobile than homeowners, and this affects the unemployment rates.  In the chart excerpted from Dr. Oswald’s study, we can see two examples that tend to prove the rule.  Of course, there are other reasons why Greece has a drastically higher unemployment rate than Germany, which is why the country is so far above the trend line.  BTW, Greece’s neighbor on the chart is Spain.

Around the Globe 10.28.2013

Pending Home Sales Show Sharp Drop – WSJ.com.

Pending Sales of Existing Homes Slump by Most in Three Years – Bloomberg.

Pending home sales drop 5.6 percent in September.

U.S. pending home sales fall by most in more than three years in September | Reuters.

NAR Pennding Home Index through 09.2013

The MFP is rightly attributing this fall in pending home sales to the precipitous rise in mortgage rates since May, though the NAR would have you believe that the shutdown beginning on October 1 somehow affected pending sales from September.  Houses have become dramatically more unaffordable since May from rising rates and housing prices against the backdrop of stagnant incomes.  The only way for the housing market to improve at this juncture would be from gains in consumer income, which is not in the cars.

 

Hilsenrath to Wall Street: You don’t know Fed.

QE Infinity? No end in sight for money printing.

In Fed and Out, Many Now Think Inflation Helps – NYTimes.com.

Fed Balance Sheet vs. SP500 Last Year

If you wish to know the Fed’s future money printing output, this is the only chart you need to understand.  The Fed buys bonds, and the sellers invest those proceeds into stocks raising prices.  When the Fed stops or even threatens to stop, the whole trade begins unraveling. While the Fed claims to be concerned with unemployment and inflation, the Fed is extremely apprehensive about the consequences of a falling stock market.    Going forward, the Fed will continue to use low inflation and poor labor market data to justify continued printing to support both the government bond and stock markets.

Analysis: Convalescent euro zone seeks to escape debt overhang | Reuters.

Currency Woes Batter Europe’s Industrial Giants – WSJ.com.

EURUSD 10.28.2013

From Yahoo Finance

The Eurozone and the MFP is really counting on PIIGS exports continuing their rise in order to support the Eurocrisis Recovery Narrative.  Unfortunately, a rising euro will stop the export “boom” in its tracks.  The Euro will continue to rise as the Fed continues to print.  Moreover, Eurozone banks are still selling overseas assets to bolster capital ratios back home.  This process has created  background buying pressure on the euro that may even pick up as these backs clean up their balance sheets in advance of the commencement of the “banking union” in late 2014.

Not happy at work? Wait until you’re 50 or older….

This article is typical of the drivel spewing from the mouth of the MSM.  People report increasing job satisfaction after 50 because of some rather obvious selection bias.  People switch jobs several times over the course of their careers.  If your job sucks, you quit it in the hopes that the next job will be better.  This process will continue until you find a job that you enjoy.  Then, you will stay with it as long as you can.  It is not surprising that people settle into a comfort zone with their employment when they reach the last stages of their careers.  So the article’s advice to sit around and “just wait” until you’re 50 is poor advice.  It takes a lot of work to obtain satisfying work, so get to work already!

Around the Globe 10.18.2013

Spain’s ruling party hit by fresh slush fund allegations – FT.com.

Spanish Bad Loans Soar To New Record High | Zero Hedge.

Spain Bad Loans

Chart sourced from ZeroHedge

Spain’s “recovery” continues.  If you Spanish stocks or bonds, you have done nicely since the Draghi pledge over a year ago.  Workers continue to reel from the effects of a poor labor market.  Spain must institute draconian reforms within its economy if it is to have a fighting chance at growing again.  Unfortunately, the country’s political system is basically paralyzed with the Prime Minister and ruling party spending political capital on defending themselves against the revelations of the PP’s slush fund. Meanwhile, the banking sector that was supposedly fixed a few months ago has just set a new record for nonperforming loans.

While the country is no longer in immediate danger of defaulting, it will continue down the path of economic despair.  An ineffective government cannot create and implement the necessary reforms to free and stimulate the economy while Spain is forced to operate under Germany’s monetary policy.  Get used to the unemployment rate and lack of growth, Spain, because they aren’t going anywhere.

Insight: Europe’s bold vision hits trouble | Reuters.

Eurozone Unemployment Selected Countries

The Eurozone is in dire straits.  The common currency has cleaved into separate, distinct areas.  In the periphery, employment and particularly youth unemployment are at record highs.  The core is performing adequately in these areas, but unemployment rates have begun to rise.  Periphery banks are reducing their lending to the private sector while increasing their domestic sovereign debt holdings.  Core banks have no such issues with private credit creation being sufficient to promote economic growth.

Eventually, the periphery will begin rebelling against the German monetary regime, but until that happens expect the employment picture to slowly, but inexorably, deteriorate over the coming months.  No one knows when the system will break, but break it must.

China Growth Rebounds After Li Stimulus to Meet Target – Bloomberg.

China GDP Grew 7.8% in Third Quarter – WSJ.com.

China GDP grows 7.8% in the third quarter.

China Annual GDP Growth US Annual GDP Growth

Yea!  Woo-Hoo! The mainstream media loves hyping China.  The Chinese GDP growth rate rose 30 bps to an annualized pace of 7.8%.  This figure is above the government’s 7.5% goal, so keep buying those Chinese stocks.

There are two reasons one should be skeptical about Chinese GDP.  The first is that the figure is politically managed.  The real world is messy reflected by volatile economic data, like GDP growth.  Note our charts above.  In the last six reported quarters, U.S. economic growth has ranged from 0.1% to 3.7%, a spread of 3.6.  Chinese economic growth has logged a 7.4% low with a 7.9% high for a mere spread of 0.5.  Mind you, this is a country that shuts down several times a year for days causing wild seasonal fluctuations in other data sets.

China is not in danger of an imminent collapse, but the country has slowed down appreciably from it peak growth.  This dynamic will increasingly act as a headwind to world growth.

As for the second reason why one should treat Chinese economic data skeptically, you’ll have to keep reading.

Heard on the Street: China Rebound Fails to Reassure – WSJ.com.

Infrastructure drive powers China’s growth prospects – FT.com.

China GDP

What goes up, must come down.  Recessions are normal.  These down periods give the economy time to reallocate resources so that productivity increases ultimately lead to rising GDP and employment levels.

Once politicians figured out that they will be blamed for the twists and turns of the business cycle, they began trying to prevent contractions.  The two methods for accomplishing this objective are government spending and money printing.  This has been occurring for years, but credit growth is reaching an important juncture.  The diminishing marginal returns of stimulus are fast approaching zero.  The U.S. has printed almost $3tr extra dollars and has added over $6tr to the government debt since Lehman, and this has only added $1.4tr to GDP.  That’s over a six to one ratio.

China is nowhere near that poor ratio, yet, but it is well on its way.  Chinese officials wish to maintain power, and they will create as much yuan as is necessary to accomplish their goal.

China Credit Growth

Around the Globe 08.07.2013

Spain Bond Returns Double Italy’s on Rebound: Euro Credit – Bloomberg.

Bloomberg Spanish, Italian and German Bond Indices

PIIGS debt has performed well since Draghi pledged to do whatever it takes to save the euro.  A central bank can conceal liquidity problems with money printing and the threat of more money printing, but it cannot fix deep rooted structural problems.  Spain, Italy and the rest of the periphery still suffer from inflexible labor markets, an ill-fitting common currency and oodles of economic red tape.  Spain is also muddling through the aftershock of its burst property bubble.

The mainstream media glosses over these problems using a sell-side industry shill to make its point:

“We currently favor Spain over Italy and we think the outperformance can continue,” said Russel Matthews, a money manager at BlueBay Asset Management in London, which oversees $56 billion. “The fundamental picture in Spain is likely to improve more than in Italy. The economy is slightly more dynamic and has a better chance of taking off.”

Italy’s economy has no chance of taking off, so Spain’s chances are little better.  Both economies will shrink more than 1.5% this year and are affected by different levels of political turmoil.  Reforms and budget cuts have ground to a halt, and only a revival of Euro-market woes will push these countries in the right direction.

Those bonds have gained nicely in the last year, but he who sells first, sells best.

German Industrial Output Rebounds in Sign of Recovery – Bloomberg.

German Industrial Production MoM

The mainstream media enjoys taking a small data set and extrapolating optimistic results from it.  While German industrial production rose in July, using this data to proclaim an end to the Eurozone recession is poor analysis.  Today’s Chart of Truth shows what has occurred after this number rises to around 2%.  Since the eurocrisis began, Germany has avoided a deep recession but not stagnation.  Going forward, decreasing output in China, Germany’s best customer outside the Eurozone, will continue to create economic headwinds for the German economy as one good month does not a recovery make.

China HSBC-Markit PMI 07.24.2013

Analysis: Euro and emerging economies and equities switch tracks | Reuters.

HSBC Emerging Markets Index

Uncle Ben giveth, and he taketh away. Emerging markets have been contracting since early 2012, and the markets finally catching up to the fundamentals.  Central bank money printing can distort markets temporarily but eventually things like supply and demand get in the way of central planning.  Despite the swoon since May, emerging markets are still expensive.  Europe’s rally since the Draghi pledge has also made its stock markets very expensive.  If something cannot continue, then it will stop.  Good luck trying to figure out when.

BOE Gives Rate Pledge, With Caveats – WSJ.com.

UK Unemployment Rate 08.2013

Every industrialized economy has been underperforming in its own special way since the onset of the GFC in 2008.  The U.K.’s unemployment rate jumped from just about 5% to over around 8% where it remains stuck today.  The labor market must be in even worse shape than we thought.  Carney has promised to maintain easy money until the rate falls to 7%, which will be two points above expansion lows.  Just as in the U.S., money printing will levitate all sorts of asset markets while failing to create a labor recovery, but this will not prevent Carney from adhering to central banking dogma.

ING Warns on Dutch Economy – WSJ.com.

NEVI Netherlands PMI

The Dutch economy has stagnated since the beginning of the eurocrisis.  Unsurprisingly, the Dutch are extremely realistic about this.  Mediocre economic figures are routinely spun into the msm recovery narrative here in the U.S., but the Dutch tell it like it is.  ING believes that the Netherlands will return to growth in 2014, but I am not so sure.  There is still a lot of air in the Dutch property bubble, so real estate values will fall further and bad loans will rise in response.

Around the Globe 07.10.2013

Why China Delivered Such a Big Miss in Trade Data.

China Exports Unexpectedly Drop; Imports in Economy Drag – Bloomberg.

China warns of ‘grim’ trade outlook after surprise exports fall | Reuters.

China Trade Data Show Weakness – WSJ.com.

China’ Crude-Oil Imports Fell in the First Half – WSJ.com.

Chinese Exports 07.2013 Chinese Imports 07.2013

The Chinese economy is heading for a recession, and this has massive implications for the rest of the world.  Commodity prices except for oil will continue to tumble, and Chinese imports will also continue their descent restraining growth in the Eurozone and the entire industrialized world.

Economists believe that China will not enter recession because their models already include a provision for no export growth; however, exports are actually decreasing, and shrinking imports show that China is producing less no matter what the official numbers say.  Moreover, the PBOC’s efforts to control an inflating credit bubble will also crimp growth.  A worldwide recession is in the cards for 2014.  The trends illustrated on our charts are ominous and unmistakable.

EU Unveils Bank-Crisis Plan With 55 Billion-Euro Fund – Bloomberg.

EU Lays Out Single Resolution Proposals for Distressed Banks – WSJ.com.

Bank Asset to GDP Germany

German GDP vs DB Derivatives 07.2013

The last thing the Germans and their FANG coalition members want is an independent European Commission deciding which banks need to be shuttered and resolved.  They oppose this power claiming that it would require a treaty change.  Keep in mind that since the Eurocrisis began, the EU and ECB have been ignoring all of those various treaty provisions, particularly the one against financing governments.

There are two real reasons that the Germans oppose granting the EU the power to shut failing banks.  First, the dodgiest bank on the Continent is probably Deutsche Bank.  The charts show that it is truly TBTF with a derivatives exposure of over 20 times the size of the German economy with assets of one-third of German GDP.  Second, the Germans will not create another contingent liability prior to elections.

Perhaps the Eurozone can use this delay to craft a better banking union.  As it stands today, there is no joint depository insurance scheme, and the resolution fund of €70bn is woefully insufficient.  Moreover, the bank-sovereign link remains intact because of rules that permit sovereign bonds to be held on the books at 100% of par value.  The Eurocrats could have used this relative market calm of the last year to craft a real solution to fix the monetary union and spur growth.  Instead, they have just persisted in their old habits borrowing and spending.

Gold-Oil Ratio Declines to Lowest Since 2008: Chart of the Day – Bloomberg.

Gold to Oil Ratio 07.2013

Once again the mainstream media fails to… Wait a second.  Lo and behold, I wrote too soon.  This is actually a fairly accurate assessment of the oil and gold markets.  Oil prices have risen due to increased economic activity combined with the standard Middle Eastern crisis premium.  Meanwhile, the price of gold is sinking as people realize that the world will not end tomorrow or even next month.  Gold is probably done sinking for now, but oil could move upward if tensions you-know-where escalate.

Wholesale Inventories Unexpectedly Drop as U.S. Sales Surge – Bloomberg.

Wholesale inventories fall, likely drag on GDP growth | Reuters.

Inventory to Sales Ratio 07.2013

It is a mathematical fact that shrinking inventories subtract from GDP growth, which is one reason why GDP calculations are flawed.  Our chart shows the inventory/sales ratio, which is actually hovering around the lows seen during an expansion.  Perhaps, manufacturers will increase production to replenish inventories over the next few months leading to higher growth or maybe they are reducing production in response to falling orders with this trend continuing instead.  As you can see, economic indicators remain mixed.

In the Race to the Bottom, US Dollar Falls Behind.

WSJ Dollar Index 07.10.2013

The U.S. dollar is up over 10% from its pre-election lows.  A strong dollar is an excellent inflation fighter in our country at the expense of curtailing exports.  This is probably one of the reasons that new export orders have decreased two months in a row:

US Manufacturing PMI Components 07.2013

The strong dollar also causes inflation in emerging markets.  As these currencies weaken, food and energy become more expensive as these goods are priced in dollars.  This dynamic will continue to weigh on world growth.

Currency Controls in Cyprus Increase Worry About Euro System – NYTimes.com.

Cypriot Bank Deposits through 04.2013

These controls were put into place almost four months ago, so it’s nice that the mainstream media is finally catching up to the rest of us.  Here is my March 26 post discussing the ramifications of capital controls in Cyprus:

Cyprus No Longer in Eurozone | DARECONOMICS.

The controls implemented as part of the 1st Cyprus bailout created a new de facto currency, the junior euro, J€.  The J€ is so far used only in Cyprus, but it will probably spread to other periphery trouble spots. J€’s give the market the illusion that the Eurozone will not break up so that institutions can continue buying gobs of that sovereign debt while presenting it to the ECB for cash to buy even more.  While this game of musical chairs is currently keeping the Eurozone afloat, it will make everything worse when the unwind actually begins.

Poland Considers Euro Membership

Poland Warily Revives Debate on Adopting the Euro – WSJ.com.

This is not a Polish joke.  Poland is actually considering euro membership.  Fortunately, the stupid Pole is just a stereotype propagated by years of inappropriate comments, and  Poles are actually against euro adoption by over a two to one margin.  Despite the lack of political support, ill-suited economic fundamentals, and depressions and recessions caused by euro membership in countries with similar economies, Polish politicians are attempting to sell euro membership to the country.

The article states,

The emerging consensus is that for the common currency to regain its allure, euro-zone institutions from regional bank supervision to the fund set up to rescue countries in trouble need to be significantly strengthened.

My question is emerging consensus among whom? The people are strongly opposed to euro membership, so the implication must be the elite.  The good news is that the Germans will not pay any more money to strengthen European institutions, so the currency may not regain its allure for the elite for quite some time.

Fundamentally, Poland is ill-suited to join a currency union with Germany.  Then again, so were Italy, Spain, Greece and Portugal, but that didn’t stop them.

Poland runs  a consistent current account deficit with its own currency subject to its own monetary policy tailored for the peculiarities of its economy.  What will happen when it begins using a Teutonic-strong euro?

poland-current-account-to-gdp

Moreover, its labor market is uncompetitive with its own currency.  Disaster will result if Polish workers are forced to compete with the uber-productive Germans.  Polish unemployment is almost triple the German rate, and this number will get worse if the Poles are forced to compete against the Germans within the same currency zone.

poland-unemployment-rate

Poland needs to retain its own currency and the freedom to set a monetary policy for Poles, not be forced to adhere to the ECB’s policy for Germans.

Poland Prepares 2015 Referendum on Euro Membership

Poland GDP Growth

Poland opens way to euro referendum – FT.com.

You would think that there’s gotta be a Polish joke in here somewhere, but that is not the case.

Poland has endured years of insecurity due to its precarious geographic position in the middle of Europe.  Since the end of the Cold War, Poland has been slowly coming into its own by joining the multinational organizations of the West.  A minority of Poles wish to continue the journey by joining the eurozone.

Prime Minister Tusk is gambling that this minority will grow into a majority by the time elections roll around in 2015. Basically, his actions reveal that he believes that Europe will have overcome the Eurocrisis by the time Poles go to the polls for the euro-referendum.

With Eurozone GDP continuing to decrease while more countries join the bailout dole, his gamble is either audacious or delusional.  Only time will tell which.

Periphery’s Problem with the Euro

Growth Rates IT GR SW UK

Embattled Economies Cling to Euro – WSJ.com.

This is a very interesting article from the Wall Street Journal. The one question that I had been asking myself as the Eurocrisis dragged on is why are the people of the peripheral countries so intent on remaining within a currency union that is so damaging to their economies?

The answer is that they associate the euro with economic growth and view it as a check on their own corrupt governments. Citizens in the PIIGS overwhelmingly favor retaining the euro by a margin of over 3 to 1, so these countries will not voluntarily revert to their national currencies anytime soon.

The view on the euro is succinctly stated in the piece:

Across Europe’s southern rim, people recoil at the idea of returning to national currencies, fearing such a step would revive inflation, remove checks on corruption and derail national ambitions to be part of Europe’s inner circle.

Italy is used as an example of these widely held opinions. Several Italians give their views including businessmen and a geologist. The article reports the misconceptions that citizens have about the euro.

These people associate the euro with economic growth, but the association is based on the luck of timing. When the euro was adopted, the West was emerging from a mild recession. In the chart above, we see that euro countries and non-euro countries both experienced good growth up until the Great Financial Crisis. Sweden may have exhibited the most robust economy during the time in question.

Mr. Martinetti said he doubts Italy would have been able to finance its huge national debt with a sinking lira and high interest rates: “I think the euro saved Italy.” Mr. Martinetti thinks that the euro saved Italy, but this is a misconception. What the euro did was push off the day of reckoning for Italy’s massive debt pile. Adoption of the euro forced down Italian interest rates. By reducing the yearly interest expense paid to finance itself, Italy was able to continue on this path for several more years exacerbating the situation until it finally exploded in 2011. Today’s crisis fighting efforts are merely a temporary respite from the march to default. Italy must drastically restructure government spending and its economy in order to arrest the crisis. So far, it has not made much progress in its pursuit of these goals.

“We haven’t done as well under the euro as Germany has because we’re not led by people who are able to bring the potential benefits to Italy,” said Mr. Grasso, the winemaker. This is the key problem with the euro. The Italians, Spanish, Portuguese and Greeks do not have the German political system. The FANG countries have less red tape and corruption. If the periphery wishes to share a currency with those countries, then it needs a political system that is able to create and implement the necessary reforms to make their own economies and governments as efficient.

People get the government they deserve. Whenever a government has attempted to curtail state entitlements and job protections, it has summarily been thrown out of office. This has happened in each of the PIIGS, France and, yes, even Germany.

The people want two conflicting things. They want to remain in the euro, and they want to avoid the consequences of doing so. This not unlike Americans who think the large budget deficit is a problem but do not wish to reduce Social Security, Medicare or defense spending.

“The answer is not to throw the euro out, it’s to look at what’s not working and fix that,” said Giovanni Ricci, a geologist from Turin. What is not working is that several different economies are sharing a currency. The peripheral countries need to make theirs as efficient as the others, but they refuse to do so. This is creating two eurozones, a rich and a poor.

“Italy without the euro would be far worse off.” We have no way of knowing if this is true. Is there an parallel universe where Italy does not join the euro and Monti wears a goatee?

Maybe in this hypothetical place, Italy is forced to deal with the debt problem in 2004. The Bank of Italy devalues the lira by monetizing the debt and causing inflation. As the country spirals deeper into economic disaster, the great statesman Berlusconi enacts a serious of harsh economic reforms. The country returns to growth courtesy of an export-led boom. In response to economic good times, the Italian birthrate rises reducing the severity of the demographic situation ahead. Italy avoids the eurocrisis and grows nicely while Spain and Greece burn.

Since life is a statistical sample of only one, we will never know what would had happened had Italy not joined the Eurozone. A few years ago it received benefits from the currency, and now it is dealing with the consequences.

The Eurozone could work, but no one seems willing to do what is necessary. All of the countries need to reform their economies while they become joint and severally liable for each others debts and banking systems. At this juncture, none of these conditions seem likely to be implemented.

Euro Stength and the Two Charts That Matter

Mario Draghi Gets the Euro Where He Wants It – The Euro Crisis – WSJ.

Draghi Signals Euro Strength May Hurt ECB’s Recovery Efforts – Bloomberg.

ECB says will monitor impact of euro strength | Reuters.

Financial commentary has become very skewed towards divining what the utterances of the oracles of central banking mean to us mere mortals. All of the mainstream media coverage regarding the strength of the euro and its recent downtick revolves around what Draghi is saying, and no one bothers to check the fundamentals.

Even analysts are deferring more to central banks rather than examining the numbers themselves. I wrote about this trend here, Yen Weakens in Line with Fundamentals | DARECONOMICS. in terms of the recent weakness of the yen. The same analysis applies to the euro.

The euro will continue strengthening. Where it will stop depends on how much the ECB balance sheet shrinks. Outstanding LTRO’s declined €140bn from over €1trn to €873bn since banks were allowed to begin repaying them a few weeks ago. The second tranche of loans will be repaid beginning on February 28. As a show of strength, banks will repay a large sum on the first day of eligibility, shrinking the ECB’s balance sheet further:

Fed to ECB Balance Sheet

From the Wall Street Journal

Furthermore, the Fed’s balance sheet is set to grow €85bn per month for the next year or so. At that rate, the euro may even cross the $1.40 barrier.

The other chart that points to a stronger euro is the balance of trade between the eurozone and the world:

Eurozone Balance of Trade

We are on an upward trajectory here. Declining imports in the austerity racked periphery and a revival in exports among those countries and Germany will increase the trade balance over the coming months. This dynamic will cause an increase in the demand for euros raising the price as the supply decreases due to the ECB’s shrinking balance sheet.

Draghi can flap his gums all he wants, but his words will only cause a temporary respite in the euro’s rise. In order for the ECB to achieve a weaker euro, it must operate on the supply and demand of euros. This entails a monetary expansion of some kind. Currently, the Germans are completely opposed to this, and they’re the ones running the show.

FANG and PIIGS Continue to Diverge

Euro Fair Value

Analysis: Euro overshoot will rekindle bloc-wide tensions | Reuters.

Exports of goods and services (% of GDP).

Morgan Stanley FXPulse 20130117.

Some eurozone countries are losing the currency war, but others are winning. The euro has a different effect on each country that uses it. The Germans are using a vastly undervalued currency which drives their export machine, but the Greeks must use an overvalued currency, which is choking the life out of the country.

The euro crisis narrative places the blame on the peripheral countries for their spendthrift ways, but the real problem is Germany. Since it is the largest country accounting for over a quarter of the Eurozone’s GDP, the euro tends to skew towards the valuation of the old  mark.

There are two Eurozones. One is comprised of the FANG countries whose exports account for at least 41% of GDP lead by the Netherlands (83%) with Austria(57%), Germany (50%) and Finland (41%). The PIIGS plus France have exports accounting for one quarter to one third of their GDPs with the other countries belonging to each group depending on its export percentage.

These numbers are important because they debunk the “Export to Growth” myth that has been repeated ad nauseam over the last few months:

Standard & Poors analyst Frank Gill said Spain, Portugal and Ireland have all made ‘rapid progress’ in rebalancing economies via rising exports and to countries outside the zone. He expects all three to return to current account surplus in 2013 and said that will hasten a return to growth well ahead of forecast.

When exports account for one-third of an economy, that tiny portion must grow at a fantastic rate to counteract the drag from government cuts and reduced consumption.

Let’s say Spain increases its exports by 10%. This sector of its economy is 30% of GDP, so a 10% rise will add 3 full points to GDP growth. However, at the same time, savage budget cuts, reduced consumer spending and investment are reducing the other 70% of the economy more than enough to keep Spain’s economy shrinking. A 5% decrease in this portion subtracts 3.5 points from growth resulting an overall shrinking economy.

The article also mentions the internal devaluation ongoing in the periphery. “Internal devaluation” is a euphemism for wage cuts. When people earn less money, they spend less and they cannot afford their pricey mortgages financed when their property and their income was much higher. What is really needed here is an external devaluation, but that would require countries to revert to their old national currencies.

The PIIGS and France would all benefit from leaving the eurozone, but the Germans will do whatever it takes to keep the currency area together. They have an undervalued currency, which is still strong enough to maintain a low rate of inflation. Why would they ever want to leave the Eurozone? For example, the price of oil has risen 20% in dollar terms since November 7 but only 12% in euro terms:

Oil Price in Euros 02.06.2013

Meanwhile, the German economy alone will probably resume growth in 2013:

January Markit PMI Germany

While the Germans like to talk about a grand political union, what is really driving their actions is maintaining the very good deal they receive from the Eurozone.

The French, God bless them, may actually believe in a political union, because they are sacrificing a great deal by remaining within the common currency. The French economy is performing poorly in line with its overvalued euro:

January Markit PMI France

France will not leave the eurozone, but Italy just might. Silvio Berlusconi has a chance to lead the government again, and he has already mentioned a lira reversion.

As long as these two Eurozones exist side-by-side, the breakup risk will never totally dissipate. ECB money may lower rates and raise stock markets in the short-term, but in the long-term drastic economic reforms are necessary in the both Eurozones. The PIIGS require more efficient labor markets, and the FANG needs to rely less on exports and more on consumption to drive growth. Until these reforms are implemented, the specter of break up risk will hover over the continent.