By Axel Merk for Merk Investments
If it looks like a duck, quacks like a duck, it just might be a duck. We are talking about the euro: it now looks like a currency, acts like a currency, it might as well be yet another currency. The new framework of the European Central Bank (ECB) morphs the euro from a currency of nations to a currency of the United States of Europe. This has major implications on how to value the euro and with it, the U.S. dollar and other currencies.
Going forward, as weak nations in the Eurozone ask for help, they cede sovereign control over their budgets. In return, the ECB is ready to deploy its (unlimited) resources to lower their respective costs of borrowing. Crucial in this context is that politicians in the Eurozone, not the ECB, approve the help. Also crucial is that the ECB ‘conditionality’ merely requires, as ECB President Draghi puts it “broad lines, leaving it up to the governments themselves what the precise shape is.”
Many rightfully point out that this may simply help weak countries to ‘kick the can down the road’, or even to hold stronger countries hostage: think Spain that thinks it has done enough and will ‘demand’ help without engaging in further structural reform. No kidding. And indeed, the silver lining of the high cost of borrowing has been that major structural reform was pursued because of the “encouragement” of the bond market. But what does it mean for the euro?
When it comes to the U.S. dollar, British pound, Japanese yen, the respective central bank’s policies guide the short-term borrowing costs for their governments. In the Eurozone, there’s “fragmentation” as weaker countries have a substantially higher cost of borrowing than stronger ones; in ECB President Draghi’s words, the “monetary transmission mechanism” is broken. The new policy addresses that by providing a mechanism to have such rates converge. But he is not only imposing a rate convergence, he is also imposing a political convergence given the requirement that governments give up sovereign control over their budgets.
What one ends up with is what one would expect from a central bank: borrowing costs more in line with what the central banks like to see. Draghi correctly points out that the new framework will only be effective if supported by sustainable fiscal policy. But he also points out that this is a challenge no different from the challenge of any other central bank.
There’s only so much that monetary policy can do; central banks cannot solve fiscal problems. We can only hope that the Federal Reserve has tuned in and heeds that advice. Fiscal issues must keep politicians busy – that’s what they are elected to do. We may not be satisfied with the state of fiscal affairs in the Eurozone, but are we satisfied with the state of fiscal affairs in the U.S.? In the U.K.? In Japan? The Eurozone is growing up, but that doesn’t mean fiscal challenges will evaporate.
The European Central Bank, in its own words, has created an “effective backstop to remove tail risk from the euro area.” That is correct and justifies the rally we have seen in the euro in recent weeks in anticipation of today’s announcement. Money has been flowing from pricey currencies that benefited from the “everything but the euro” trade, including the U.S. dollar, to the euro. As this new framework settles in, we expect to see further euro appreciation.
Thereafter, we can look at the euro like any other currency with all the good and bad that comes with it. We don’t expect a disengagement of the rather activist approach by policy makers. As such, the currency market will, in our assessment, remain a formidable place where the ‘mania of policy makers’ will be reflected. Such activism is not good for capital allocation, but that’s a global, not a Eurozone challenge. While the U.S. is busy contemplating QEn+1, the Eurozone will provide stimulus by lowering the borrowing cost of peripheral Eurozone countries. If the promised sterilization of the ECB’s Outright Monetary Transactions (OMT), as the new program is called, is implemented effectively, the U.S. Dollar might get a mighty competitor, even as we continue to be confronted with politicians the world over ducking the tough choices. (my emphasis)
By Axel Merk, President and Chief Investment Officer, Merk Investments
By permission Axel Merk
The Merk Hard Currency Fund is a no-load mutual fund that invests in a basket of hard currencies from countries with strong monetary policies assembled to protect against the depreciation of the U.S. dollar relative to other currencies. The Fund may serve as a valuable diversification component as it seeks to protect against a decline in the dollar while potentially mitigating stock market, credit and interest risks—with the ease of investing in a mutual fund.
The Fund may be appropriate for you if you are pursuing a long-term goal with a hard currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Fund and to download a prospectus, please visit www.merkfund.com.
Investors should consider the investment objectives, risks and charges and expenses of the Merk Hard Currency Fund carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Fund’s website at www.merkfund.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.
The Fund primarily invests in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Fund owns and the price of the Fund’s shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Fund is subject to interest rate risk which is the risk that debt securities in the Fund’s portfolio will decline in value because of increases in market interest rates. As a non-diversified fund, the Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. The Fund may also invest in derivative securities which can be volatile and involve various types and degrees of risk. For a more complete discussion of these and other Fund risks please refer to the Fund’s prospectus. Foreside Fund Services, LLC, distributor.Print This Post Send To A Friend