The Euro continues to trend lower against the Dollar as the recent turmoil in Greece’s government bond markets has started to spread to Portugal and Spain too.  Events are starting to spiral out of control, evidenced by 10-year Greek bond yields rising from below 6% to more than 7% over the past few weeks (inflicting losses on the buyers of Greece’s €8 bln 6.2% 2015 bond which was issued on 25th Jan 2010).

Eight billion euros is only the first instalment on the €53 bln which Greece needs to raise in 2010 and it is this impending refinancing need which will bring matters to a head sooner rather then later.  Greece is now in the market’s spotlight and is really in trouble because this particular bond market storm is not going to simply blow itself out and go away.

The panic in Greece’s bond market is going to have to get a whole lot worse and this will eventually force the rest of the Euro-zone to act.  The markets don’t believe that the Greek government will be able to impose austerity measures on the Greek public (public demonstrations and strikes have already started).  ECB President Trichet has been quoted as saying ”We expect and we are confident that the Greek government will take all the decisions that will permit them to reach their goal”.  What else can he say?  If he told the truth and said they were stuck like pigs in a poke and the squealing would have to get a whole lot louder before they get bailed out, then Greece’s bond market collapse would intensify and yields would rise even more rapidly.

The endgame is fast approaching and it will not include the IMF lending money.  The bigger and more stable members of the Euro cannot allow Greece to be rescued by the IMF and thereby show the whole world that Euro-land can’t manage its own internal affairs.  Whatever tax-raising promises get made by the Greek government are irrelevant (as only time will tell whether they can actually impose the promised tax rises on the Greek public) as Greece does not have the luxury of time on its side.  

The end of this crisis will be signalled by a large amount of money being loaned to Greece by any or all of the following : Germany, France and the ECB.  Watch out for a classic euro-zone “enhanced credit support” fudge whereby the ECB suddenly decides to embark upon Quantitative Easing which involves the purchase of large quantities of euro-zone members’ government bonds.  The EU itself cannot extend a long-term loan because it also represents non-eurozone members.

Markets are going to become even more disorderly before this panic is over but the bigger picture is that this is a panic in the PIIGS’ government bond markets and, whilst it may impact other markets in the short-term, the resolution of the crisis will provide a buying opportunity across multiple asset classes.  The Euro will keep trending lower against the Dollar (and Sterling to a lesser extent) until the crisis is resolved because the resolution may involve the ECB printing a few hundred billion euros.  The ECB will then have joined the other major central banks in the Race to the Bottom and, as usual, the ECB will once again have proved itself to be the slowest to act.

So two central banks have led the way and raised interest rates (Australia and Norway), starting their journey on the long way back to interest-rate normality.  But it does not necessarily follow that just because two commodity-linked countries have started to hike rates, the Fed, BoE and the ECB are about to follow suit anytime soon. Speculation that the Fed and BoE are contemplating rate hikes is way too premature – the order of events will surely be for Quantitative Easing spending to be halted first and only then will the central bankers turn to taking back some of the rate cuts they have implemented since the summer of 2007.

The US has recently reported GDP turning positive in the third quarter of this year but the US economy is still far too weak for the Fed to risk halting QE anytime soon, let alone even think about raising interest rates from their current floor of 0.25%. One positive quarter of GDP is just the start of a potential recovery  (which could easily fizzle out again next year) and the Fed made it clear in their Fomc statement earlier this week that rates are staying put “for an extended period” and the Fed won’t even finish spending its current $1.75 trillion QE money until the end of March 2010. As was announced today, US unemployment is still rising and has now reached 10.2%.

Similarly the Bank of England this week increased by £25 bln its QE target to £200 bln, to be fully spent by the end of January 2010.  The BoE will most likely decide to print even more money if GDP does not return to growth in Q4 (after the surprise of the UK posting another quarter of recession in Q3).  As the BoE will not raise rates ahead of next year’s General Election, theoretically the ECB is in line to be the first of the major Western central banks to implement a rate hike as they never embarked upon QE in the first place.  However the jury is out on whether the ECB will raise rates with Spanish unemployment of almost 20% and with Ireland looking set to go to the IMF to seek a loan.

Inflationary pressures will not be seen in the UK until a lot more of the £200 bln QE money finds its way off deposit at the BoE (where £151 bln currently sits) and out into the wider economy where it can begin to chase the price of goods & services higher.  Therefore the BoE will only come under pressure to raise rates in the near term if the Pound Sterling collapses.

So the sight of central banks raising rates looks to be spotted for the time being only in the economies of the world which export commodities.  China will probably be the first Asian central bank to increase rates because the Yuan is closely tied to the US Dollar and other Asian countries do not want to raise rates and cause their currencies to appreciate against the Dollar or the Yuan.

One of the old routes for a traveller from England through France and on to Italy passed through the French city of Troyes, situated between Reims and Dijon (nowadays at the junction of the A5 autoroute (from Paris) and the A26 autoroute (from Calais) – the A26 is still called the Promenade des Anglais and to this day sees a steady procession of vehicles bearing UK plates heading to & from the Channel).  Many centuries ago the only way for travellers to pay for goods & services was with gold & silver coins.  Troyes gave its name to the troy ounces in which gold is still traded today.

However there was no standardised system of weights & measures in the Middle Ages and merchants who travelled across Europe had to contend with each different city they arrived in having its own definition of how much an ounce or pound weighed.  There were the pound of Toulouse, pound of Cologne, the Wool Pound, Mercantile Pound and London Pounds.  Pity the poor traveller who was handed an ounce of gold in one city which weighed less than an ounce of gold when he got to Troyes.  Never mind the fact that there are 12 Troyes ounces in a Troyes Pound but we all know today that there are 16 ounces to the pound we use in cooking, etc (strictly called the Avoirdupois ounce).  And we haven’t even touched upon the Kings’ habit of debasing their currencies by having coins minted of alloys which contained progressively less and less than 100% pure gold – there were many ways in which the merchants of the Middle Ages could be hoodwinked! 

Silver is also traded in troy ounces.  Sterling Silver is an alloy which contains 92.5% pure silver (the rest is usually copper).  Centuries ago the Spanish minted silver and gold coins.  The Spanish silver coins were called Reales and a 1 Reale coin contained 0.125 ounces of silver.  Thus the 8 Reale coin contained one ounce of silver - the 8 Reale coins were the Pirates’ fabled Pieces of Eight.

Gold is once again in the headlines now it is trading above $1,000 per troy ounce.  The Comex gold futures contract (symbol GC) is based on 100 troy ounces of gold which means if you own one contract at expiry you will receive 3 one-kilogram gold bars of at least 99.5% purity.  This is not quite 100 troy ounces of pure gold but it makes the GC futures market function better.  Being short-changed in gold is something people have got used to over the centuries!

In terms of grams, a Troy ounce = 31.1034768 grams whereas an Avoirdupois ounce = 28.349523135 grams.  Curiously a Sterling Silver coin weighing exactly one Troy ounce contains nearly one Avoirdupois ounce of pure silver, just as today’s Krugerrands (made of 22 carat gold alloy) actually weigh more than a Troy ounce so as to contain exactly one Troy ounce of pure gold.

So don’t fall for the age-old trick of thinking that your 9-carat rose gold bracelet which your kitchen scales tell you weighs one ounce is worth anywhere near one thousand dollars.  In fact as rose gold is usually gold alloyed with copper and 9-carat gold only contains 37.5% gold, your rose gold bracelet would be more accurately be described as a copper bracelet.  All that glitters is not gold – as the merchants may well have said in the taverns of Troyes after a good day’s trading in the Middle Ages!

All this currency printing (Dollars, Sterling, Yen & Swiss Francs) by central banks as they engage in their various forms of quantitative easing is leading to a depreciation of their currencies against real assets. This is being disguised by talk of currencies engaging in competitive devaluations against one another but eventually it will show up in the price of real assets increasing as measured against these fiat currencies. By real assets we are talking about Oil, Real Estate, Gold and Equities (the first three of which God ain’t making any more & equities are a claim on nominal GDP). Government bonds are being propped up by heavy central bank buying and may well remain expensive for years (there is no point in fighting concerted central bank buying of government bonds – John Maynard Keynes pointed out that “markets can stay irrational for longer than speculators can stay solvent”). Don’t read too much into “failed auctions” of Government bonds such as happened this week in Gilts – this is a brave new world and market participants are still feeling their way towards what they should be paying the DMO for 40-year gilts when the BoE is busy buying 5- to 20-year paper. The head of the DMO (whose job it is to sell gilts as expensively as possible) should have kept quiet rather than allow himself to be quoted as saying “Yields at these levels are not all that attractive”. However the general idea to issue longer-dated gilts than the BoE is buying back is surely the correct strategy for the DMO to execute whilst gilt yields are this low, even if the execution is proving a little untidy at times.
As usual the ECB is the slowest of the Western central banks to act – they have yet to commence quantitative easing but the central bankers of Portugal, Ireland, Italy, Greece & Spain (collectively called the PIIGS) must be praying for the ECB to start buying government bonds soon as there are few other buyers of PIIGS bonds at the moment and they have lots to sell. The ECB has a practical problem to overcome if & when it decides to implement quantitative easing, namely which eurozone countries does it choose to favour by buying their government bonds? If the ECB wishes to ease tight credit conditions then it should logically buy the PIIGS’ bonds and squeeze their yields back down towards German levels (the great “convergence trade” would be back on with a vengence), in the process helping to allay market fears about any of the PIIGS leaving the Euro. Once could reasonably expect squealing from any eurozone country whose bonds were not purchased by the ECB. Not a pretty problem for the ECB to overcome whilst other central banks already have the printing presses rolling flat out.

Post-Script (23 April 2009) :  One possible way for the ECB to execute Quantitative Easing would be for the ECB to spend its money by buying equal amounts of each eurozone member countries’ government bonds.  In this way the policy could be sold as being “fair” to all whilst having the desired side-effect of a greater impact on the PIIGS due to the smaller size of their economies relative to Germany, France, et al.