Predictions 2009 Joseph Trevisani fxsol.com

Prediction is a dangerous game, particularly for currency analysts. But in honor of the year end we will dignify a few guesses about 2009 with the term long term analysis. This one time in the year we will ignore the honored analyst’s dictum: provide a price or a date but never both.The European Central Bank (ECB) has again succumbed to the seductive belief that the EMU economies live in a parallel universe. It is a universe where the United States and Japan can fall off the economic cliff but the Europeans can dance on the edge. Recent talk from the ECB governors has been all about inflation. The ECB refinance rate is at 2.5% while the American and Japanese rates are effectively zero and negative in real terms. The European governors are hoping that their economies will not collapse and that their rhetoric will forestall inflationary union wage settlements. But hope is not an economic policy and recession and deflation will dampen union wage demands without assistance from the ECB governors. There is no logical reason to believe that the EMU economies will not perform as badly or worse than their industrial counterparts around the world. If the US and Japan see the need for zero rates, how can the ECB board stop at 2.5%? Fact is they probably won’t. The ECB is not finished cutting rates no matter what Jurgen Stark may say. But by letting the market see their reluctance to lower rates further the governors risk setting up the same type of market reaction that we saw in July. Perhaps a much weaker euro is desired by the governors? It was the mid-July admission by ECB president Trichet that EMU economic growth would be much weaker than predicted that sparked the vast sell off in the euro and the yen crosses. Until mid-summer Trichet had been steadfast in maintaining that inflation was the problem and that the US financial crisis would stay on the western side of the Atlantic . Judging by the euro rate against the dollar in late June most currency traders must have believed him. By returning to their anti-inflation rhetoric are the ECB governors deliberately prepping the euro for a fall? Probably not. Inflation talk from the ECB boosts the euro so even if there were a surprise rate cut the currency will just have that much farther to fall. The unease of the ECB board members with an avowed rate cutting policy is of a piece with the bank’s charter and its stabilizing role in the EMU. But any recovery in the euro based on a rate disparity of 2.00% or more with US or Japanese rates is doomed to disappointment. Do the ECB governors think they can put a floor on European rates at 2.00%? Again probably not. But for the ECB there is no cost to keeping up inflation appearances. The only folks likely to be harmed are currency traders who, as in July, believed the governors’ words rather than economic facts and may have gone long the euro at year-end. Japan and the United States have embarked on rate and fiscal policies almost unprecedented in modern times. Nominal base rates in both countries are close to zero; real rates are negative. The American government and the incoming Obama administration are planning the largest fiscal stimulus package in history. This enormous increase in government spending is aimed not at the private sector but at government jobs, it is essentially a huge increase in government payrolls. These twin rate and fiscal policies are not quite unprecedented. They have been tried once before and they were largely a failure. In the early part of the decade the Bank of Japan kept interest rates at zero percent for more than five years. The Japanese government enacted stimulus package after stimulus package pumping billions of yen into the economy. But the economy refused to recover. Japan too had a banking crisis. Banks were unable to lend because of the vast burden of bad property loans leftover from an earlier property bubble. The problem with government spending is twofold: first it is limited in duration, and second it creates nothing. Jobs on the government payroll are jobs totally dependent on government largesse. Government appropriation means taxes or in this case borrowing. When the jobs program ends no firm has been established to continue employment. It is the private economy that creates sustainable expansion because only it creates firms and products that when successful provide permanent employment. No amount of government spending can compensate for a moribund private sector. Government jobs are essentially make work jobs, not that they might not perform needed tasks but when those tasks are done, unless government spending is to continue at the same rate the jobs are lost. Workers then have to repair to the private sector to find permanent employment. Government borrowing also crowds out private sector funding. Every penny of the one trillion or more dollars that the Obama administration will probably spend on economic stimulus will have to be borrowed from the market. Lenders will have a choice; give money to relatively risky private ventures at a premium rate or to the US government at a very low and safe rate. In the current environment many will choose to lend in safety to the federal government. The economic effect is that some or many private ventures will not get funded. The jobs that they might have created will never arrive. But despite these issues the United States is at least addressing its economic problems. The ECB and the national governments on the continent are not. The ECB in particular may sustain its inflation reputation but in the long run its credibility as a central bank will suffer far more from a prolonged recession. The trust so painstakingly assembled over the past decade as the custodian of European prosperity could be seriously damaged. And wither the ECB so the euro.And this brings us back to the predictions. The market will hear the ECB inflation rhetoric and then see the ECB rate cuts and likely traders will punish the euro for the deception. EMU economic recovery will be delayed by the very late start of the ECB in cutting rates and the paltry economic stimulus programs of the states; the European recession will keep the euro down. The euro will reach 1.2000 by mid-year and 1.1000 by year end. If this comes true please write, if not, please forebear