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Is Draghi's Ultimatum Killing the Eurozone?

By: Benzinga
Posted: 1/29/2013 7:01:00 AM
Referenced Stocks: FXE;FXY;GLD

Investors all remember European Central Bank President Mario Draghi's speech last August where he said that the ECB would do anything in its power to protect the euro. Five months later, credit spreads of peripheral nations ensnared in the debt crisis over those of safer nations have narrowed, showing at least some success of Draghi's ultimatum.

However, Draghi's announcement of the Outright Monetary Transaction (OMT) program had one negative effect for the Eurozone that could inevitably weigh on the world economy. By defending the euro, defending individual nations' solvency, Draghi created a large dilemma for both himself and the Eurozone as a whole.

The strength of the euro has been somewhat remarkable since Draghi's ultimatum. The EUR/USD rallied sharply after the announcement through the end of the year as investors no longer feared a break-up of the euro. In short, the euro rallied not because it was fixed but because it would still exist in the future. The imminent break-up risk of the euro had been removed and markets re-priced this risk.

The strong euro will eventually cost Europe dearly though. As PIMCO CEO Mohamed El-Erian wrote in the Financial Times Tuesday, "with growth already sluggish, the eurozone can ill afford a stronger currency. Sharp appreciation undermines economic activity - not only for export powerhouses such as Germany but also for countries such as Spain where, for the past eight quarters, the contribution of net exports has been positive."

"Expect the ECB to be pressed hard to join other central banks in actively seeking to depreciate the currency - by cutting the policy rate (currently 0.75 per cent) and quantitative easing of the type pursued by the Bank of England, the Bank of Japan and the US Federal Reserve." El-Erian also warns that, should the ECB enter the devaluation game, it would truly mark the beginning of a global currency war.

Remember, currency wars and export-driven growth is a zero-sum game. If the Bank of Japan weakens the yen, it weakens relative to another currency. Therefore, as much as Japanese exports get a boost from a weaker currency, the other trading partner's currency strengthens and their exports decline. If countries compete in a game of devaluation, fiat currencies will all decline and no currency will devalue all that much relative to another.

In this game of currency wars, the only solution for investors is to invest in real assets that hedge away fiat currency cash flows. Investors could buy inflation linked bonds, gold, or real estate as real assets that provide could provide real income no matter what happens to fiat currencies.

(c) 2013 Benzinga does not provide investment advice. All rights reserved.

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