EUR, USD Exchange Rates Hint at Fresh Financial Crisis
Recent reports from the International Monetary Fund have shaken the financial world as crisis rhetoric is moving from whispers to shouts. But are we really headed towards a repeat of 2008? Given the lack of understanding as to the true reasoning behind the most recent crash, it is hard to gauge whether we are headed down that path again.
One thing is for certain, however. Exchange rates have been vastly affected since the financial crisis in 2008. Prior to the crash, the Euro to Pound Sterling (EUR/GBP) exchange rate was sitting comfortably between 0.90 and 1.00, but in 2014 the rate is on the 0.80 mark and continuing to decline.
Global Economy on Crash Course
To fully understand whether we’re living on financially thin ice, it is perhaps prudent to assess the shortcomings which led to the crash in September 2008. We all know that the crisis was brought to the world’s attention after the global heavyweight bank Lehman Brothers collapsed, but what triggered the slump to bankruptcy?
Foolish Financiers
Many economists have attributed the origins of the crash to a spate of irresponsible mortgage lending in the US. In the build up to the crisis, American financiers were dishing out loans to borrowers with poor credit histories and without the means to make adequate repayments.
‘Clever’ bankers sought to make these ultra-risky loans into low-risk securities by pooling them in large groups. Pooling can be effective if the loans aren’t correlated or of similar origin, but financial engineers argued that property markets from city to city would change independently of one another. Hindsight is both a cruel and wonderful phenomena as financiers found to their cost after the American housing market endured a nationwide crash.
In the aftermath of the American housing market slump, the fragile nature of the financial system was exposed. Sophisticated financial engineering wasn’t enough to provide the promised protection to investors. Mortgage-backed securities devalued to such an extent that they became practically worthless and banks began to question the validity of their counterparts.
Regulatory Oversight
It is undeniable that financiers’ failures were at the core of the crash, but they aren’t solely responsible. Central Bankers and other regulators certainly didn’t come out of the situation looking innocent.
Perhaps the most significant error, from a regulatory standpoint, was to allow Lehman Brothers to go bankrupt in the first place. Allowing the bank to wither without intervention resulted in Government bailouts. And as a result of this lackadaisical approach, regulators had to rescue many companies to curtail the consequent panic.
All in all, the last financial crisis cannot be pinpointed in terms of blame, but was as a result of huge risk taking by financiers and regulators respectively.
How did the Financial Crisis Effect Exchange Rates?
As central banks strived to stimulate growth by dropping their benchmark interest rates to record-lows, exchange rates were completely altered. Ultra-low interest rates encourage traders to take risks on the global currency market, bolstering risk-correlated assets and fostering safe-haven declination.
From 2008 to 2014 the Pound to US Dollar exchange rate has trended in a far lower range than the period prior to the crash. In 2007 the GBP/USD exchange rate was holding firm within the range of 1.95 to 2.15, but from 2008 to 2014 the range has been unable to move away from the 1.55 to 1.75 region.
Are We Headed for a fresh Financial Crisis in 2014?
To be frank, forecasting a financial crisis is not easy, which is why 2008 was such a shock. However, with economists more savvy as to the indicators, we ought to be better prepared should one arise.
It is fair to say, however, that there are some concerning factors which support the view that we are headed down a difficult road.
Exchange rates are a good indicator of the likelihood of a fresh financial crisis. Every exchange rate – whether it be major players, emerging market assets, commodity-correlated or risk-sensitive currencies – have declined a significant amount from pre-crisis levels, and many economists agree that they will never reach those peaks again.
Loose Central Bank Monetary Policy
Six years after the start of the crisis central banks are still locked in a sustained period of ultra-low interest rates. The Federal Reserve benchmark rate is at 0.25%, the European Central Bank interest rate is at an unprecedented 0.05% and the Bank of England are holding only fractionally higher at 0.50%.
In addition to record-low bank rates the central banks have also employed extensive stimulus measures which were designed to pull the benchmark rate higher and bolster economic security. Given that the central banks have held their rates for so long, and economic stagnation is a reality for many countries, it is possible that the stimulus is not only failing but adding to the downfall.
International Monetary Fund
A recent report from the International Monetary Fund suggests that we are in danger of heading towards a financial crisis. As stated on their website; ‘The International Monetary Fund (IMF) is an organization of 188 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world.’
The most recent Global Financial Stability Report stated; ‘Monetary accommodation remains critical in supporting the economy by encouraging economic risk taking in the form of increased real spending by households and greater willingness to invest and hire by businesses. However, prolonged monetary ease may also encourage excessive financial risk taking. Although economic benefits of monetary ease are becoming more evident in some economies, market and liquidity risks have increased to levels that could compromise financial stability if left unaddressed’.
In short, it seems that traders have been using the low interest rates to increases risk taking on financial markets, rather than appropriate risk taking to encourage the domestic economic recovery. The report continued to say; ‘conflicts of interest between bank managers, shareholders, and debt holders can lead to excessive bank risk taking from society’s point of view’. José Viñals, the IMF’s financial counsellor, confirmed this idea; ‘Policymakers are facing a new global imbalance: not enough economic risk-taking in support of growth, but increasing excesses in financial risk-taking posing stability challenges.’
Global economic stagnation can be seen in exchange rates. For example, the Euro to US Dollar exchange rate was comfortably holding in the range of 1.55 to 1.65 in 2007. In 2014 the EUR/USD exchange rate is trending in the range of 1.25 to 1.35.
Europe’s Very Own Financial Crisis
Is Europe the new Japan? The answer from the IMF boss, Christine Lagarde, was yes. ‘There is a serious risk of that [recession] happening’ she added. ‘But if the right policies are decided, if both surplus and deficit countries do what they have to do, it is avoidable.’
The European Central Bank have dropped their benchmark interest rate to an unprecedented 0.05% and initiated stimulus measures in the form of buying repackaged debt. The Head of Germany’s Bundesbank, Jens Weidmann, criticised these extreme measures stating; ‘In my view the recent decisions by the ECB Council (are) a fundamental change of course and a drastic change for the ECB’s monetary policy […] No matter how you think about the content of the decisions, the majority of the ECB Council members are signalling with it that monetary policy is ready to go very far and to enter new territory.’
Having been in place for some time it appears that the stimulus package hasn’t had the desired effect as the Euro exchange rate has softened considerably over the past few months.
Echoing comments he made in mid-2012, ECB President Mario Draghi has repeated his ‘whatever it takes’ party line. Only having stopped short of fully-blown quantitative easing measures, there is little more the President can do to counteract Eurozone stagnation. Francois Savary, chief investment officer of management firm Reyl & Cie., stated; ‘It’s the realization that there’s a real limit to his ‘whatever it takes’ promise, any signs that US growth won’t do as well as expected throws markets into a panic because it’s still carrying the global economic recovery on its shoulders.’
So where do we stand?
In truth it is incredibly difficult to foresee a financial crisis, and even harder to forestall one. Evidence suggests, however, that global economic growth has cooled considerably and may never return to pre-crisis levels. It is also very likely that the 18-nation currency bloc is headed towards a recession (for more detail read http://www.futurecurrencyforecast.com/eurozone-heading-triple-dip-recession-will-euro-eur-exchange-rate-slide/30648).
What you can be sure of, however, is that the longer the Central Banks opt to hold ultra-low interest rates the greater the chance of encouraging reckless risk taking.
Snail-paced global economic growth is a reality and can be seen in exchange rates. For example, before the crisis the Pound Sterling to Euro (GBP/EUR) exchange rate was trending in the range of 1.45 to 1.60, but in 2014 the exchange rate is trending between 1.15 and 1.30.
