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Euro Fractures, Gold Leaps

It's only a short step to catastrophe for the Euro, says the Gold Price...

FOR ALMOST A DECADE, writes Gary Dorsch of Global Money Trends, the yields on bonds issued by different Eurozone governments moved close together.

By joining the Euro-bloc currency regime, every member state could suddenly reap the benefits of "free-riding" in the Eurozone bond market, or borrowing at almost the same interest rates as Germany, no matter whether or not the country's economic fundamentals justified those lower rates.

But as the global financial crisis gathered speed last September, yields across the 16-member Eurozone bond market – as driven by bond prices – started to diverge. Global investors became more selective, and started demanding higher interest rates from member states with large budget and external trade deficits.

Gold, the Euro and Bonds: Yields Diverge Wildly

Eurozone yield spreads have now diverged more widely than at any time since the introduction of the European single currency in 1999, with Germany enjoying the lowest interest rates and Greece and Ireland having to offer the highest.

This change raises skepticism about the long-term viability of the Euro itself, and has sparked a flight into Buying Gold as a safe-haven. Already, three Eurozone economies – Spain, Greece and Ireland – are under heavy attack from the global banking crisis and credit rating downgrades. There are concerns that Portugal and Belgium may be next.

Currency union may have narrowed the wide-gap between the richer and poorer nations of Western Europe, but the good times also masked the underlying structural differences between the various economies. These gaps are now becoming more visible as the global recession deepens.

On January 29th, the Die Zeit newspaper wrote how "The global banking crisis is widening the interest rate gap between the Euro countries. Serious economists are wondering when the first state will go bankrupt. After that it's only a short step to catastrophe – the collapse of the currency union."

Membership of the Euro-currency was originally tied to strict budgetary discipline. The annual deficit of a member country's government was to be limited to a maximum of 3% and its total debt to 60% of the country's gross domestic product (GDP).

But for many years, Greece, Spain and Italy took advantage of the easy money that came their way, borrowing beyond their treaty-set limits, while their trade deficits remained wide. But this January the Standard & Poor's credit ratings agency downgraded Greek debt to "A minus", citing its current account deficit of 14% of its gross domestic product – the highest in Europe.

A year ago, Greece could issue 10-year bonds priced to yield just 0.5% more than Germany's Bund – the benchmark of prudent stability.

But the trade surpluses earned by Germany are no longer being recycled back into Greece and other less prosperous Eurozone countries. Instead, Greece has become a favorite target for the European bond vigilantes. And little wonder. Greece expects to borrow €43.7 billion this year, pushing its total debt-to-GDP ratio to match almost the country's entire €250 billion annual output.

Without the crutch of Euro membership, Greece could not have attracted foreign investors at interest rates anywhere near Germany's low rates, not while its economy ran a trade deficit of €36.5 billion euro. (Germany, the world's biggest exporter for the past six years, earned a surplus of €178 billion on its foreign trade last year.) Standing alone, the pre-Euro Greek Drachma would have plunged, sending Greek bond yields even higher.

Gold, the Euro and Bonds: ECB Split

The European Central Bank (ECB) has meantime slashed its key repo-rate by 225 basis points since October to 2.00%, unwinding a tightening cycle that spanned the previous 30 months. Yet despite the drive towards sharply lower ECB rates, yields on Greece's 10-year bond have begun to move in the opposite direction, climbing 125 basis points higher even as the yield on Germany's 10-year Bund have tumbled by 75 basis points.

And in lockstep, the Gold Price in Euros has risen from €540 an ounce in September to above €765 an ounce today, tracking the widening interest differential between the German Bund and the weakest link in the Euro-bloc.

One of the drawbacks to membership of the Euro-bloc is the lack of sovereignty over the nation's domestic money supply. The electronic printing press, often utilized by central banks to monetize a government's debt, is largely controlled in the Eurozone by the Bundesbank hawks, working in prudent unison with ECB chief Jean Claude Trichet in Frankfurt.

The ECB hawks reject the increasingly popular embrace of "Quantitative Easing" now being adopted by central banks in London, Israel, Japan, the United States, and even Switzerland in order to combat the destructive force of deflation. The Euro-bloc also precludes member states from unilaterally devaluing their currencies, in a beggar thy neighbor strategy, to boost overseas exports.

Spain's 10-year debt has just sunk in price too, pushing yields half-a-per-cent higher since the beginning of this year.

That might not seem unusually large on the surface, but it is actually quite destructive considering that an underlying trend of deflation is seeping deeper into the Eurozone economy.

Measured in Euros, the Dow Jones Commodity Index is 38% lower than a year ago. So it's only a matter of a few months before official data agency EuroStat begins to report consumer inflation turning sharply negative. But while government and media commentators are still attempting to assure the public that there could be no repeat of the 1930s' deflationary spiral – leading to global depression – the commodity markets are telling a different story.

Deflation is seen as a precursor to depression, because falling prices generate less cash flow to companies, reducing their ability to pay-off debts, which in turn, can lead to a vicious cycle of mass layoffs, production cutbacks, and weaker consumer spending.

For Spain, higher bond yields and mortgage rates are especially worrisome, since the number of Spanish jobless has risen by one million workers in the past 12 months as thousands of small businesses, which employ around 80% of the workforce, lose access to easy credit and can't roll-over their debts.

The Spanish jobless rate rose to 14.4% in December, twice the average of the European Union, while industrial production has plunged by 20% from a year ago. So Bundesbank chief Axel Weber is telegraphing a half-point ECB rate cut to 1.50% next month, because "We should not avoid lowering interest rates aggressively, because we understand at this current juncture, all indicators look like the Euro-zone economy is in free-fall," he says.

Bundesbank hawk Juergen Stark, on the other hand, is warning that the ECB should not adopt Quantitative Easing, otherwise known as "printing money", to lower Euro-zone bond yields. "Overly aggressive reductions in our policy rate when we cannot see any risk of deflation would exacerbate and not resolve uncertainty," he says.

"Those who advise us to go to zero interest rates and then experiment at the zero level are not those who are responsible for the possible consequences."

Greek central banker George Provopoulos sees the situation very differently – the worst since the Great Depression of the 1930s in fact.

"The outlook for the global and the Euro-area economy in 2009 appears dismal," he just warned. "The current crisis is the biggest since the 1930s and exiting from it will not be easy or quick."

Foreign direct investment into Greece fell from €31.3 billion in 2006 to just €4.6 billion last year. The Athens stock market index, the ASE General – which was trading at 5,000 points a year ago – has tumbled to 1,800 points, hard hit by a sharp drop in tourism and ship building, which accounts for 25% of its economy.

Greek central banker Lucas Papademos has even gone a step further, saying he would support the use of unconventional tools at any time, such as "Quantitative Easing" – otherwise known as printing money in order to buy corporate or government bonds. Papademos indicated that the ECB wouldn't necessarily have to cut rates to zero before expanding its monetary policy toolkit.

"Any measures that may be deemed appropriate to improve the functioning of markets and help stabilize the financial system may be taken independently of the level of policy rates," he said.

Gold, the Euro and Bonds: Luck of the Irish Runs Out

A year ago, Ireland's debt to GDP ratio was among the lowest in the Eurozone at 41%. At one juncture, Ireland's 10-year bond was yielding 25 basis points less than Germany's!

Ireland enjoyed an economic boom from the late 1990s, expanding at more than double the average growth rate across the 13-nation Eurozone with high-tech multinationals arriving to take advantage of its 12.5% corporate tax rate – one of the lowest in Europe – and earning it the nickname of the "Celtic Tiger".

But the Irish Republic's economy was the first to slide into recession in the Eurozone last year, its first setback since 1983.

Irish house prices fell 9.1% during 2008, compared with a fall of 7.3% in 2007, and are expected to fall 10% in the year ahead. The average home price in Ireland was €261,600 in December, down from €287,900 at the end of 2007 and €310,600 at the end of 2006.

The global credit crunch forced the collapse of a decade-long bonanza in Ireland's housing market, culminating in a move by the Irish government on January 15th to take Anglo Irish Bank into full state ownership.

The move came as fears that a collapse of the bank, due to toxic mortgages and other bad debts, would bring down the entire economy. The decision reversed a previous move to pour €1.5 billion into the bank while leaving it independent.

This was all part of a €5.5 billion package to prop-up the three major Irish banks – Allied Irish, AIB and the Bank of Ireland – as agreed in December. Ireland's finance chief Brian Lenihan made clear that full state control was the only way to prevent a catastrophic run on the bank, with €80 billion of customer deposits outweighing assets.

"The damage to the country's reputation in trashing deposits and refusing to honor obligations will be enormous," Lenihan said.

Ireland is a key financial hub in Europe, administering €1.7 trillion of funds, and at its peak in 2007 AIB was worth €21 billion. But it is now worth €528 million. Over the same period, the Bank of Ireland's market value has fallen from €18 billion to €340 million. In 2007, total Irish financial stocks together were worth €59.4 billion. Now they are worth €1.65 billion.

Both AIB and the Bank of Ireland are reported to have large volumes of bad debt similar to Anglo Irish. For the moment these banks remain outside full state control, but they are in dire need of additional cash infusions.

Ireland's government debt has now become the riskiest in the Eurozone, surpassing Greece's sovereign bonds for riskiness according to credit-default swap (CDS) insurance rates.

Part of the reason is Dublin's guarantee scheme for the debts held by Irish banks. It's more than 11 times the size of the entire Irish economy. So CDS traders are betting that the possibility of widespread bank bailouts will drive up government borrowing at a time when the worst economic slump since the Great Depression curbs tax revenue.

Credit-default swaps on Irish government bonds jumped 95 basis points to a record 355 basis points last week, the most of any Eurozone country. This rate compares to 265 basis points insuring against a default by Greece. (A basis point on a credit-default swap contract insuring €10 million of debt from default for five years is equivalent to €1,000 a year. Iceland retains the riskiest debt ratings of the industrialized nations with contracts on its government debt at 995 basis points.)

The transfer of credit risk from the private sector to the public sector, in bailing out the banks, is adding Anglo Irish's property portfolio to the government's expanding debt, putting its strained public finances under even more pressure. Ireland's Treasury is set to borrow some €15 billion this year, taking the total national debt towards the €70 billion mark, but that number can climb far higher. The European Commission predicts the budget shortfall in Ireland will reach 11% of GDP this year.

Gold, the Euro & Bonds: Gold Tracks the Fracture

The recent run-up in Gold Prices versus the Euro, up more than 22% so far this year, is tracking the widening yield spread between Irish and German bonds, mirroring the same pattern seen with Greek bond spreads.

While the current yields on Eurozone bonds do not suggest that any member state is in danger of defaulting on its debt, the divergence in yields represents the first cracks in the Euro currency regime.

If the Eurozone's economic downturn morphs into a 1930s' style Great Depression, the temptation for weaker member states to opt-out of the Euro regime in favor of currency devaluation – such as the devaluation recently engineered by the Bank of England for the British Pound – or by enacting central bank monetization of government debt, might become unavoidable.

That's the message of gold's rally versus the Euro coinciding precisely with diverging Eurozone bond yields versus the benchmark German Bund.

Gold hit a record €770 an ounce on February 17th after a report by ratings agency Moody's sparked fresh fears about the deteriorating health of Western European banks, especially those with big loan exposure to Emerging European countries.

The global financial crisis has forced Hungary, Ukraine, Belarus, Latvia and Serbia to seek more than $35 billion in emergency loans from the IMF to stave off default on their bonds. Ukraine led a rise in borrowing costs across the region, with the extra yield offered by Ukrainian bonds compared to US Treasuries rising to a record high 32.25% this week.

At the same time, investment in the SPDR Gold Trust (GLD) – an exchange-traded trust fund holding physical gold to back its exposure to the Gold Price – rose 14% last week to a record 985 tons, mirroring a flight from the Euro into the yellow metal.

Western European banks have bought up most of emerging Europe's banks. But as emerging European currencies weaken by the day, the rising cost of loans taken out in foreign currencies such as the Swiss Franc, the Euro and the Yen is pushing many borrowers into default.

Since August, would-be Euro member Hungary has seen its Forint drop about 28% versus the Swiss Franc and 23% versus the Euro. Hungary's total stock of foreign currency mortgages rose to 2,374 billion Forints ($10.2-billion), or about 9% of the country's entire GDP, in December.

The banks with the greatest exposure are primarily located in six countries – Austria, Italy, France, Belgium, Germany and Sweden. They account for 84% of the claims on Emerging Europe. The Bank for International Settlement – founded during the Great Depression of the 1930s – indicated last week that Austrian bank claims on emerging European clients totaled $277 billion, or 75% of Austria's GDP.

For Sweden, claims mostly on clients in the Baltic countries of Estonia, Lithuania and Latvia represent 23% of GDP and for the Netherlands, exposed mostly to Polish, Russian and Romanian borrowers, this is just under 16 percent.

GARY DORSCH is editor of the Global Money Trends newsletter. He worked as chief financial futures analyst for three clearing firms on the trading floor of the Chicago Mercantile Exchange before moving to the US and foreign equities trading desk of Charles Schwab and Co.

There he traded across 45 different exchanges, including Australia, Canada, Japan, Hong Kong, the Eurozone, London, Toronto, South Africa, Mexico and New Zealand. With extensive experience of forex, US high grade and corporate junk bonds, foreign government bonds, gold stocks, ADRs, a wide range of US equities and options as well as Canadian oil trusts, he wrote from 2000 to Sept. '05 a weekly newsletter, Foreign Currency Trends, for Charles Schwab's Global Investment department.

See the full archive of Gary Dorsch.


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