Last Sunday, in the first round of French presidential elections, incumbent Nicholas Sarkozy came in second to Socialist Party candidate Francois Hollande. The second and final round of voting will be on May 6 between the two.
If Sarkozy wins, the status quo in Europe will prevail -- so we will concentrate the discussion here on what happens if Hollande wins.
A Hollande presidency will cause investors to immediately question the French commitment to the Maastricht Treaty, the European Union and the euro. German chancellor Angela Merkel also stands for reelection next year, and although support for her is very high among the German people, in the wake of a Hollande victory investors will begin to wonder if the electorate in Germany may shift, too.
The recently completed regional elections in Germany were mixed. Merkel's party, the Christian Democrats (CDU), did well, but their junior coalition partner, the Free Democratic Party (FDP), put in a very poor showing. I will discuss this in more detail in another column.
One of the principal platforms of the Maastricht Treaty, the agreement signed in 1992 that allowed for the creation of the euro and laid out rules of fiscal policy to be abided by the member states, is the stability and growth pact (SGP). The SGP mandates that member states' sovereign annual fiscal deficits comprise no more than 3% of gross domestic product -- and that total federal debt take up no more than 60% of GDP.
Although every member, including Germany, has consistently been in violation of these terms, their enforcement became a priority when it became apparent that Greece's sovereign debt was continuing to grow rather than shrink after it joined the Union. This eventually led to Greece defaulting on its debt, with other member states facing similar circumstances -- most notably, Portugal, Spain, Italy, and Ireland. Although the European Central Bank has been able to create mechanisms to prevent a contagion of cascading defaults so far, all of these countries are still in a precarious fiscal position.
Throughout the process of figuring out how to manage this issue within the Union, and in order to prove to international investors that they can handle the situation, one of the key alliances has been a Sarkozy-Merkel, French-German coalition on austerity. Hollande however, is not a supporter of austerity for France and has run on a platform of more fiscal spending to stimulate growth.
What's troubling about this is that France's deficit and debt levels are already well above the SGP limits at around 5% and 85%, respectively. If France breaks the austerity pledge with Germany, it will be difficult to impossible for the Union to impose fiscal austerity restrictions on the rest of the members.
The most probable course is for the euro to continue to depreciate toward, and eventually reach, parity with the dollar, a level not experienced since 2002. While this would occur under a Sarkozy presidency as well, it would be accelerated under a Hollande presidency. Even so, the process would still likely take years to complete.
The euro is currently valued at around 1.32 vs. the dollar. As the euro depreciates, it is also reflected in a rising U.S. dollar -- which is reflected again, principally, in falling commodity prices, because they are globally priced in U.S. dollars.
Putting aside all other variables, a decline of the euro to parity with the U.S. dollar would require a downward move of some 25% from current valuation -- which also means a commensurate appreciation of the dollar. Again, putting aside all other variables, this alone would cause a 25% reduction in commodity prices, the most important of which is oil. Falling oil prices would also cause falling gasoline prices and this would be beneficial for the domestic U.S. economy.
A rising dollar would also cause U.S. exports to increase in price and hurt business's relying on them. A rising dollar caused by a falling euro would also push global capital reserves toward the U.S., as well as to U.S. Treasuries. That should cause yields on long-end U.S. sovereign debt to decline further.
Ultimately this trend should result in the dollar, euro and yen reaching parity with very sovereign similar yield levels and curves.
The 10-year sovereign yields for the U.S., Germany and Japan are currently 1.95%, 1.70%. and 0.92%, respectively. If U.S. Treasury yields move toward those prevailing in Europe, and if both areas migrate toward Japanese yields, as I believe is probable, the cost of new debt in the U.S. will continue to fall. A 1% yield on the 10-year bond would imply a sub-3% 30-year fixed-rate mortgage -- and that could become the catalyst for a resurgence in housing activity in the U.S.
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