The late Milton Friedman’s prediction that the euro would not survive its first crisis is looking increasingly prescient. The euro weakened further against the U.S. dollar, hitting a four-year low of 1.2163 after Germany announced new financial regulations that will ban short selling of the ten largest German financial companies in addition to naked credit-default swaps of euro-area government bonds. The ban will begin tomorrow and is set to last until March 31, 2011.
BaFin, Germany’s financial services regulator, stated it is implementing these measures because of “exceptional volatility” in numerous European government bonds. Moreover, “massive” short selling has led to what the regulator considered to be extreme price movements that could “endanger the stability of the entire financial system.”
The euro had given up its morning gains against the U.S. dollar prior to the announcement, but subsequently accelerated to the downside as investors and traders speculated that further negative news for the euro may be forthcoming for Germany to institute such drastic measures.
While the new regulations may provide a temporary relief for financial markets, they do not address the underlying, fundamental cause of the problems - the inability of European governments to service their debt levels. Moreover, The European Union has not enforced the parameters of the Maastricht Treaty, specifically as it relates to the 3% debt-to-GDP level threshold. By turning the other way as numerous countries violated these terms, the sovereign debt and deficit issues in Europe have reached crisis proportions.
The European Union, if it intends to hold together the monetary union, will likely be forced to print more and more money to purchase the obligations of debt-strapped member nations. The EU is not like the United States, which can tax Connecticut to help Mississippi. There is no fiscal coordination, no central European institution with taxing and spending authority. The fiscal boundaries laid out in the Maastrict Treaty must be obeyed for the monetary union to succeed. However, they have been abusively violated, and as such, the fate of the euro appears dire. German citizens will not tolerate having their taxpayer money indefinitely transferred to the profligate government and citizens of Greece.
For an idea of how financial markets may respond to these new regulations over the longer-term, one only has to look back to the second half of 2008 - when the U.S. institutued a temporary ban against short selling in numerous financial stocks. Upon the release of the decision shares of banks, insurance companies, and others in the financial sector surged higher, but in the months to follow gave back those entire gains and subsequently crashed. During the September to October 2008 period that the SEC short selling ban was in place, the S&P 500 fell roughly 21%.
Although it is difficult to predict the likelihood of another market crash, the fact of the matter is that short sellers provide liquidity during volatile market environments, when many longer-term investors are running for the exits. Moreover, as Karl Otto Poehl - Chairman of the Bundesbank (the former German central bank) from 1980 to 1991 - stated in a recent interview with Spiegel Magazine, it is essential for short sellers to remain in the marketplace in order to draw attention to mispriced securities and risky financial assets.
Mr. Poehl went on to say that many of the parties that have been shorting European investment vehicles are “completely honorable institutes - such as banks, but also insurance companies and investment- and pension funds - which are simply taking advantage of the situation. That’s totally obvious. That’s what the market is there for.”
Providing an additional headwind for the euro was a report from Credit Suisse Group AG (CS), which predicted the European currency may fall to 1.16 against the U.S. dollar over the next three months as the sovereign-debt crisis compels the European Central Bank (ECB) to keep borrowing costs at record lows. The euro last traded at 1.16 versus the U.S. dollar in November 2003.
In a note to clients, Credit Suisse strategists, including Ray Farris in London and Daniel Katzive in New York, wrote that “The euro is now a low-yielding currency suffering a deeper crisis of confidence than we expected, with little near- term outlook for support from interest-rate policy. We think that euro-U.S. dollar will need to trade to obviously cheap levels to generate sustained buying interest in the near term.”
