Originally written in early July 2022, with some edits in October 2022. This has been highly inspired from Arthur Hayes very insightful writings that you can find here.
This is my essay to try and make sense of the ongoing events in the reserve currencies markets. It seems like this is the current drive of financial markets and economies. I’m specifically interested in the fate of the Euro, where my close ones and I live. In my perspective, it doesn’t bode well for the old continent’s currency.
I’ll first look at the causes leading to the current situation, and the consequences I see for the coming years.
Causes
1 — Money printing from the US and EU with ever lowering rates, accelerated with COVID
Since 2008, cheap money from ever lower interest rates has been the norm. Governments and companies could finance themselves at decreasing cost, and their debt level never stopped increasing. This accelerated a lot with Covid (see 2020 below) when money was needed to help the populations and maintain the system while unproductive.
2 — Inflation ramping up (mainly financial markets first)
When too much money is created compared to economic output, inflation starts increasing. It started immediately after Covid with financial markets (not reflected in official consumer inflation numbers) and moved on to food and energy more recently. The accommodating Covid money policy from states laid the right environment for consumer inflation to rise.
3 — Ukraine war: tightening of energy, commodities, and food supply in Europe and in global markets
Blend in a war in Ukraine with gas cuts from Russia and stress on food supplies, and you have the perfect cocktail for booming inflation. This is what we saw this summer with double digit consumer price increases in many countries (US, UK, Germany, …)
We can note that cutting nuclear reactors and increasing its energy dependence to Russia was a big mistake on Germany’s end.
Central banks and governments find themselves in a tricky situation: they need to raise interest rates so that inflation doesn’t go out of control, but this makes it more difficult for governments to finance themselves and keep helping the populations.
Consequences and reactions from states
1 — Central banks need to hike rates to fight inflation.
2 — US can resist a stronger hike than other economic areas (read EU), because most other countries won’t be able to finance themselves anymore if hike too strong.
The gap in the hike race has already started. The FED is the leader, while the BOJ already capitulated and is back to money printing. Edit October 2022: BOE capitulated as well after the government passed a big tax cut, reducing their future revenue.
In EU’s case, Germany, supposedly the strongest country economically, is already in trouble with a trade surplus heading towards negative territory. Winter is coming, and the energy situation is not improving. As Germany’s manufacturing plants are at a stop, this is not when the ECB are likely to become more aggressive in their rate hikes.
3 — Inflation sticks around and is reinforced in EU by a decrease in € value in USD because of the hikes are too soft. People discontent keep growing. (Edit October 2022: we are here)
4 — At some point, EU governments and the ECB won’t have the choice to either #1 hike rates aggressively → some countries default on their debt, or #2 devalue their currency by lowering rates and handing money out to people (energy bill, inflation protection, etc …)
For now, US is doing #1 and UK chose #2. My guess is that EU will start with #2 to keep the economic area from imploding. We are already seeing this with France and Germany firmly committing to helping people financially against rising energy prices.
This will devalue EUR significantly, and some countries will eventually leave the EU like the UK did. After Brexit 2020, Itaxit coming near you in 2023/2024.
In both cases, EUR is devalued and the end of the EU as we know it seems very likely.
Conclusion
In the short-term, I believe US will keep hiking rates for as long as they can. EU won’t be able to do it as aggressively because of the uneven debt levels between countries and the sticky inflation. They will have to get out of their trouble by printing € to help people and try to save their financial system.
This should very likely lead to the EUR fall, followed by a restructuring of Europe a few years later.
At some point the FED will stop raising rates and start devaluing their currency as well. When they do, the USD uptrend will reverse and $ will flow into other assets.
