The importance of separating politics and currency markets

AS THE European turmoil continues, why isn’t the euro falling to pieces before our eyes? With Eurozone policy makers blundering from one crisis to the next – at best covering up the cracks in the fiscal superstructure, at worst knocking out a supporting wall – you might be forgiven for expecting the euro to have gone Zimbabwean. Greece remains on the critical list, but the focus has now fallen on Spain as yields on Iberian debt seem to be heading out of control. The International Monetary Fund has backed the European Central Bank’s (ECB) “unconventional policies to address banks’ funding and liquidity problems” in the form of its Long Term Refinancing Operation (LTRO), despite it largely failing to gain any meaningful long-term traction. But despite all this, the euro has held up quite robustly against its major pairs.

The current crisis highlights a number of important points that FX traders should bear in mind. Though it may sound obvious, the bond markets are not the same as the currency markets – they work on different fundamentals and risk pricing. Take a look at the below chart for the stark disconnect between euro-dollar and bond spreads since 2008 to illustrate this. At the same time, it is important to differentiate between the politico-economic structure of the Eurozone and the euro as a currency and as a tradeable financial instrument – while the political structure has seen little success, the euro as a currency instrument has had better fortunes.

So why does the euro still have takers when European sovereign debt is being dumped by the truckload?

Firstly, the Fed, other central banks and sovereign wealth funds are in the market for euros to hedge against contagion risks to the US and to other economies. At the same time, the financial crisis has turned the FX markets into an ugly dog contest, and with the US making little headway in addressing its deficit woes, the greenback is inflicting little damage to the euro. If institutions and sovereign wealth funds dump their euro holdings, the truth of the matter is that there isn’t much else on the shelf to choose from.

Finally, it is impossible to overstate the determination of those at the centre of the European single currency to preserve their creation. The Eurozone is unsustainable in its current state, and it is inevitable that it will move towards ever closer fiscal union if it wishes to sustain its monetary union, even if that means shedding its weaker periphery countries.

The Eurozone is a divisive issue and something that everybody has an opinion on. But it is important not to let that cloud your vision when trading. If you are sceptical about the concept of a European monetary union, the temptation is to be overly bearish towards the euro. But this is a mistake and can leave you open to being side-swiped by the realities of the currency markets. Trade what you see in your charts and not what you want to see and your trading balance will stand less risk of going Greek.