The Euro Quacks Like a Fiat Currency, To Print or Not to Print

By: Axel_Merk

If it looks like a duck, quacks like a duck, it just might be a duck. We are talking about the euro: it now looks like a currency, acts like a currency, it might as well be yet another currency. The new framework of the European Central Bank (ECB) morphs the euro from a currency of nations to a currency of the United States of Europe. This has major implications on how to value the euro and with it, the U.S. dollar and other currencies.

Going forward, as weak nations in the Eurozone ask for help, they cede sovereign control over their budgets. In return, the ECB is ready to deploy its (unlimited) resources to lower their respective costs of borrowing. Crucial in this context is that politicians in the Eurozone, not the ECB, approve the help. Also crucial is that the ECB 'conditionality' merely requires, as ECB President Draghi puts it "broad lines, leaving it up to the governments themselves what the precise shape is."

Many rightfully point out that this may simply help weak countries to 'kick the can down the road', or even to hold stronger countries hostage: think Spain that thinks it has done enough and will 'demand' help without engaging in further structural reform. No kidding. And indeed, the silver lining of the high cost of borrowing has been that major structural reform was pursued because of the "encouragement" of the bond market. But what does it mean for the euro?

When it comes to the U.S. dollar, British pound, Japanese yen, the respective central bank's policies guide the short-term borrowing costs for their governments. In the Eurozone, there's "fragmentation" as weaker countries have a substantially higher cost of borrowing than stronger ones; in ECB President Draghi's words, the "monetary transmission mechanism" is broken. The new policy addresses that by providing a mechanism to have such rates converge. But he is not only imposing a rate convergence, he is also imposing a political convergence given the requirement that governments give up sovereign control over their budgets.

What one ends up with is what one would expect from a central bank: borrowing costs more in line with what the central banks like to see. Draghi correctly points out that the new framework will only be effective if supported by sustainable fiscal policy. But he also points out that this is a challenge no different from the challenge of any other central bank.

There's only so much that monetary policy can do; central banks cannot solve fiscal problems. We can only hope that the Federal Reserve has tuned in and heeds that advice. Fiscal issues must keep politicians busy - that's what they are elected to do. We may not be satisfied with the state of fiscal affairs in the Eurozone, but are we satisfied with the state of fiscal affairs in the U.S.? In the U.K.? In Japan? The Eurozone is growing up, but that doesn't mean fiscal challenges will evaporate.

The European Central Bank, in its own words, has created an "effective backstop to remove tail risk from the euro area." That is correct and justifies the rally we have seen in the euro in recent weeks in anticipation of today's announcement. Money has been flowing from pricey currencies that benefited from the "everything but the euro" trade, including the U.S. dollar, to the euro. As this new framework settles in, we expect to see further euro appreciation.

Thereafter, we can look at the euro like any other currency with all the good and bad that comes with it. We don't expect a disengagement of the rather activist approach by policy makers. As such, the currency market will, in our assessment, remain a formidable place where the 'mania of policy makers' will be reflected. Such activism is not good for capital allocation, but that's a global, not a Eurozone challenge. While the U.S. is busy contemplating QEn+1, the Eurozone will provide stimulus by lowering the borrowing cost of peripheral Eurozone countries. If the promised sterilization of the ECB's Outright Monetary Transactions (OMT), as the new program is called, is implemented effectively, the U.S. Dollar might get a mighty competitor, even as we continue to be confronted with politicians the world over ducking the tough choices.

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Manager of the Merk Hard, Asian and Absolute Return Currency Funds, www.merkfunds.com

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies. Axel Merk wrote the book on Sustainable Wealth; order your copy today.

The Merk Absolute Return Currency Fund seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes.

The Merk Asian Currency Fund seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Hard Currency Fund seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

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The Funds primarily invest in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Funds own and the price of the Funds' shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Funds are subject to interest rate risk which is the risk that debt securities in the Funds' portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities which can be volatile and involve various types and degrees of risk. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds' prospectuses.

This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor.

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