FX CONCEPTS FX CONCEPTS

GLOBAL MACRO RESEARCH GLOBAL MACRO RESEARCH

CURRENCIES INTEREST RATES EQUITIES COMMODITIES
To contact FX CONCEPTS New York: 1 (212) 554-6830; London: +44 20 7213 9600; Singapore: (65) 67352898; research@fx-concepts.com


MARKET INSIGHT REPORT
With Germany in Recession, the Game Has Changed
By John R. Taylor, Jr.
Chief Investment Officer
_____________________________________________________________________________
Many years ago we bemoaned the location of the ECB. Why did it have to be in
Frankfurt, as it would be more representative of the Eurozone if it were in Barcelona or
Bratislava, and if I remember correctly the third B was Bari? I didnt want the lower ECB
functionaries to be mostly German nationals and I feared that going out to lunch, and
spending the weekends surrounded by self-satisfied German burghers would make the
ECB less responsive to the real needs of its constituents. I believe I have been correct,
even though Mario Draghi helped offset this, as he seemed a stiffer sort, being from the
wrong side of the tracks (Alps) and having spent significant time in the foreign world of
MIT in Boston. Things are just beginning to change dramatically and will continue to do
so in the next year. The reason is clear. Germany has shifted from the top performer to
somewhere in the middle of the pack, as it adjusts to its new recession. Germanys
position has not sunk in yet, but it has gone from being the WunderAlte, steady, secure,
and sure of itself, to an aging society suffering from a myriad of chronic injuries, some
self-inflicted like the ban on nuclear power, the change in labor laws, and the reliance on
exports, and some just a function of age (and previous success). There is nothing
disastrously wrong with Germany, except demographics, it is just that economic activity
is cyclical. The past is our guide. Germany was racked with self-doubt, uncertainty and
internal violence in the 1980s became a superstar with the fall of the Wall lasting
through the mid-1990s but then fell to the sick-man of Europe at the end of that decade
and through the first half of the 00s. With the painful changes pushed through by the
SPD and Gerhard Shroeder, moves which probably lost the election for the SPD, Angela
Merkel inherited a sprightly retooled society ready for a run in the sun. Things went her
way as China went on a capital spending binge as central Europe and the Eurozone
benefited from lower rates buying more than ever before. But now that luck has turned.
Merkels too-quick reaction to Fukushima banning nuclear power means the cost of
power in Germany will keep driving companies offshore and cutting investment within
the country. Add in the pension reform, which allows many workers to retire at 63. Power
costs and labor availability are only part of the problem as the new minimum wage -
roughly !14k per year for a full time job - means Germanys cheapest workers are paid
wages higher than more than half the Italian workforce. This is a big break for Italy and
other countries and a downer for German business. The growing tension with Russia is
destroying Germanys fastest growing export market. Even with no further problems
arising from Ukraine, the German economy is assured of a negative third quarter and a
technical recession, something no one seems to admit. If the war footing intensifies
there is little chance of a German recovery this year and possibly not next year either. If
nothing else happens, the Eurozone is likely to slip into negative growth this quarter
despite the efforts of Spain and some others as the German, Italian, and French
numbers should overwhelm everyone else. What can the ECB do? With very short
interest rates at or actually below the zero-bound, the weapon is taken away and the
long dated rates are at historic lows all across the Eurozone too. With Bunds below
1.00% and headed lower, the recession will continue the new trend, widening peripheral
spreads. As little stimulus is available on the rates side, the ECB will have to force the
banks to lend and go further into unorthodox methods. The ECB must push its
members to at least partially support a general guarantee. The Germans must change
their tune, but it will take time. The euro will drop first as the solution will be hard to reach
and we expect the recession to gather in force.
FX CONCEPTS FX CONCEPTS
GLOBAL MACRO RESEARCH GLOBAL MACRO RESEARCH
CURRENCIES INTEREST RATES EQUITIES COMMODITIES
To contact FX CONCEPTS New York: 1 (212) 554-6830; London: +44 20 7213 9600; Singapore: (65) 67352898; research@fx-concepts.com


CURRENCY - Europe Long-Term View

The Tide Has Turned
By John R. Taylor, Jr.
_____________________________________________________________________________
Despite our continuous efforts, it is often impossible to
identify the major cyclical turns without the underlying
fundamental changes tipping the scales for us. What
our work always does is prepare us to identify the
altering character of the fundamentals before they
are apparent to most other people because the
cycles, trends, and momentums are warning us
the end is possible not certain, but possible. We
have to see the two acts together. They are doing
that now.

We have been dealing with a euro that looked very
tired to us. Our bias, developed after exactly 50 years of
studying, teaching and analyzing / predicting the process that is Europe has lead us to
be negative. My first paying intellectual job was teaching a course called European
Integration back in 1964-65. I often had to explain to US-centric friends that this had
nothing to do with blacks. No one had heard of economic integration. Europe should
have come a long way since then, but it hasnt. The battle is still the same, between a
powerful EU central authority and a union of states. Back then we had EFTA and the EU
Europe at 6s and 7s as one book was titled and today we have those in the euro
and those not in the euro. However, even within the euro, the battle rages: how much
centralization do we want? Simplistically, the rich dont want it, but the poor do.
However, the nuances are far more complex than that simple binary choice and the
unknowns make any decision treacherous. Europe has worked with this problem for 50
years and there has been no solution. It is in as bad a bind as I have ever seen. Now
with Germany in recession and declining inflation close to becoming deflation, it is
unlikely an answer, no matter how desperately it is needed, will appear in a few months.
Looking at 50 years of progress, not one of the dramatic steps along the way was ever
made without kicking, screaming, and fighting, with economic damage finally getting
severe enough to bring about a solution.

The cycles tell us the calm is over. Recession is here and there will be no growth.
Without some centralized treasury function the Eurozone will suffer a deep recession in
the next year or two and the only choices are a fiscal expansion no matter how ugly and
un-German that is (Germany will run a big deficit too) and a lower euro. Draghi is
already moving in that direction and the only opposition to that move has come from
Germany. Forget that, the Germans want the euro down as well.

Cyclically, the chart, with monthly data above, identifies May as the EUR/USD peak as
well as the peak in the reciprocal of the Dollar Index. The cycles call for a decline all
the way into the summer of 2016. The short picture shows a low in late November and
we are expecting the decline to be substantial between now and then. A drop to the 1.26
to 1.27 area would not surprise us by that time. Between now and the low in early
October, we are expecting a move to 1.3000.