Brian Andrew, CFA

Buon Giorno from Scotland!

Recently I visited Scotland for a non‐profit world federation meeting. On my way there, I wondered what the food would be like and whether there would be more than haggis on the menu. Fortunately, I found an excellent Italian restaurant managed by a large Italian family across the street from my hotel. It was like eating at a café in Florence. The Euro's weakness made the brasiola more expensive, but we ordered it anyway. The family was more than happy to discuss Italy's current political woes and the possible outcomes. On the flight home, I thought about how the Euro's weakness and Italy's political issues might be connected.

Euro Weakness

During my stay, the value of my Euros declined and the value of the dollar rose. So much so that when I arrived home, the exchange back to dollars was 2% lower. In fact, the Euro has declined by 8% since its peak on Feb. 1 (see chart below). There may be a number of reasons for the dollar's assertion of strength since the beginning of February.

The dollar's strength can be partially tied to the difference between interest rates in the U.S. and Europe. The German and U.S. economies can be considered comparable. That is to say both have reasonable growth, low unemployment and a well‐trained workforce. Yet the German 10‐year bund yield is only .38%, while the U.S. 10‐year Treasury trades at 2.9%. The reason for this difference has more to do with Italy than it does Germany.

Italy vs. Germany

The Euro is a common currency for 19 of the countries in the Eurozone. These include the likes of Germany, Italy, Spain, Portugal, Greece and the Netherlands. Of course, the economic status of each of these is very different. Some, like Germany and the Netherlands, have well‐performing economies, while others like Italy, Greece and Spain don't perform as well. Add to that the political turmoil in some of these countries and you have a recipe for some discord among Eurozone members and the potential for a deleterious effect on the Euro's value.

Last week, Spain's prime minister since 2011 was ousted due to a Parliamentary no‐confidence vote, and the Socialist party's Pedro Sanchez was sworn in. Spain's economy continues to trail behind those better performing economies in Europe like Germany and the Netherlands.

Also last week, turmoil in Italian politics led to a short‐squeeze in the government debt market. (Investors who expect U.S. Treasury prices to head lower short bonds in hopes that they can buy them back at lower prices. Turmoil in Italian politics led to investors seeking safety in the U.S. bond market—that demand caused prices to go up instead of down.) The yield on the U.S. 10‐year Treasury traded from near 3% to as low as 2.75% in a day, then recovered back to 2.9%.

The Italians were looking for new leadership and finally two populist parties were able to cobble together enough votes to put Giuseppe Conte, a law professor who has never held political office, into power. Markets were roiled because these populist parties have made noise in the past about leaving the Eurozone, although this seems very unlikely.

The Italians don't have the same economic growth and low unemployment that Germany has. Nor do they have as strong a government balance sheet. The Italian government has borrowed enough money to leave their debt to GDP (amount of money borrowed to the size of the economy) at a level that is more than twice that of Germany's. Unemployment in Italy is over 11% while in Germany it is only 3.4%. These differences mean that if Italy were to leave the Eurozone, the value of the lire would be well below the value of the Euro (of course the German mark would also be much stronger than the Euro). In the Eurozone, the weaker economies benefit from the stronger ones and vice versa.

So while political turmoil may create near‐term asset price volatility, it seems a low probability that Italy will leave the Eurozone and create economic disaster at home.

Bunds vs. Treasuries and Euro vs. Dollar

Now, back to that difference in yield between German Bunds and U.S. Treasuries. As you can see from the chart below, the difference between these two yields has grown as interest rates have risen in the U.S. much faster. The difference in 2013 was less than .5%, whereas now it stands at 2.5%. (You may have heard about the big negative return in Bill Gross' bond fund last week, primarily because he believes this spread will narrow over time. The fund is not on our list of funds).

This interest rate differential has led to some of the Euro's weakness against the dollar. Investors have come to understand that the U.S. central bank (the Federal Reserve) will continue on its path of raising interest rates while the European central bank cannot seem to get rates up from 0%. The longer it takes the ECB to move (in part, due to the weaker economies like Italy), the greater the difference in interest rates between the two developed economies, and the more attractive the dollar becomes relative to the Euro.

In addition, the U.S. economy appears to be stronger, growing between 2% and 3%, while the Eurozone is growing at less than 2%. This fact leads investors to believe that the interest rate differential between the two developed economies will remain wider for some time, which in turn has led to a weakness in the Euro relative to the dollar. (There are many inputs to the value of a currency, one of which is the earnings rate on assets in each country.)

U.S. economic strength continues to impress, but we'll have to watch the data closely for signs of weakness later this year. For now, just like my preference for brasiola over haggis, the difference in currency values is likely to persist.

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Views and comments expressed in this blog are those of the author and do not necessarily represent the positions of Cleary Gull or fellow Cleary Gull associates.