Here's currency and bond market response to EU: 'Yawn'

By George Albert

As Europe hobbled to an agreement on fiscal deficits, the equity markets rallied but the currency and bond markets yawned.

On Friday, US equity indices jumped by around 1.6 percent, the UK’s FTSE 100 by a little less than 1 percent and the German Dax by 1.9 percent. The euro, however, rose an anemic 0.31 percent against the US dollar.

Equities tend to react prematurely and often out of proportion to events. Hence it’s always good to take a look at the currency and bond markets to see if they confirm the optimism of equity markets. The bond and currency markets are more mature and generally tend to give a better picture of the long term.

[caption id=“attachment_152781” align=“alignleft” width=“380” caption=“The best way for Europe is to grow out of its deficit by adopting pro-growth policies of lower taxes and less regulation. Reuters”]  [/caption]

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So the fact that the euro did not bounce as strongly as the equity markets did after news of the European agreement broke is not good news for the financial markets. Even against other major currencies such as the yen and British pound, the euro did not rally strongly after the news.

In fact, it fell slightly against the Swiss franc. The euro-yen pair rose 0.29 percent, the euro-pound rose 0.04 percent and the euro-Swiss franc fell 0.01 percent.

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The rally in equities often shows that risk is back on the table, which should mean a strong fall in safe havens such as US bonds. But the 30-year US treasury only fell 0.09 percent and the 10-year bond 0.08 percent on Friday. Hence we’d take the rally in equities with a pinch of salt.

The reaction of the currency markets to the announcement makes sense. Under the agreement eurozone members with huge government deficits will face automatic penalties, and all governments will have some kind of laws to balance their budget.

The currency markets shrugged it off, as these ideas have been floated before. Also, the United Kingdom, a major player in Europe, vetoed key provisions of the agreement. There is a lot of distance the governments have to cover before the basics of the agreement crystallise. And again it remains to be seen if the political will exists to implement tough deficit reduction measures.

The goal to reduce deficits sounds good on paper, but the markets know better. There are several ways to cut the deficit and many are not good. One way is to increase taxes to reduce deficits. This is the worst solution as higher taxes impact growth and, in fact, reduce revenues. Raising taxes is the easiest step for the political class and bureaucrats as it is populist.

Politicians like to rail that the rich, or corporations, don’t pay their fair shareand then increase taxes. But corporations never pay taxes, they only pass it on to the consumer. And the rich find ways to avoid taxes.

The second option that governments use to reduce deficits is to cut spending. This tends to be good in the long run, but hurts the economy in the short run. It is also difficult to implement in the welfare states of Europe.

Given Europe’s socialist bias, the markets fear that the political class will cut deficits by hiking taxes and doing very in little in terms of spending cuts. This will result in the slow decay of Europe just like Japan. This explains the currency and bond markets’ lukewarm response to the deficit agreement.

The best way for Europe is to grow out of its deficit by adopting pro-growth policies of lower taxes and less regulation. Lower taxes often increase economic output which, in turn, improves tax receipts even at lower rates. But the currency and bond markets feel Europe has gone too far left to correct and grow quickly.

George Albert is Editor, www.capturetrends.com