Euro Will See A Volatile Start Says FX Analytics' David Gilmore

CONNECTICUT--With currency markets transfixed by emerging markets for the better part of the last two years, there has been little attention paid to the watershed event quickly approaching--the birth of the euro.

Politicians across Europe have successfully hypnotized the financial markets into believing the euro will happen with few hitches. While, investors and central bankers alike will take to the euro like ducks to water.

In an instant, the euro will be considered a reserve currency, they say.

Not even Walt Disney could have sold tickets to this Euroland fantasy.

Traders and investors are in for a rude awakening as the euro is certain to get off to a volatile start and financial markets, over time, are bound to challenge its very existence.

Perhaps the euro's most notable flaw is monetary union without political union. The European Central Bank (ECB) will set a single interest rate for all 11 founding members of the EMU partnership. But this will be done against the backdrop of 11 different national budgets.

Even with the stability pact including penalties for states that fail to keep deficits from widening beyond three per cent of GDP, countercyclical economic policy becomes more art and less science, with interest rates as the primary shock absorber. Add in divergent economies and the ability of the ECB to smooth the business cycle is even more suspect.

Compounding the ECB's difficult task of smoothing the business cycle is the baggage of unresolved structural problems most of the 11 bring to the party. High levels of unemployment supported by labour market rigidities make for comparatively high labour costs.

Reducing unemployment is critical to winning public support for EMU and governments seem intent on introducing new rigidities for combating joblessness.

France is attempting to reduce the working week without reducing wages and salaries. Germany, meanwhile, is considering lowering the retirement age to increase job vacancies.

Generous welfare and pension schemes are still the rule, not the exception through the EU-11. And organized labour can close commerce in France and much of the Continent to push wage demands.

While in Italy, political instability is legendary as witnessed by the collapse of the Prodi government weeks ahead of EMU.

Simply, the EU-11 are not physically fit for the marathon that begins in January.

Posing perhaps the greatest test for the euro is the shift leftward in the political topography. Calls for lower rates resonate in Germany, France and Italy under centre-left governments. However, the ECB can ill afford moving early to cut rates without putting at risk its independence.

German officials have questioned the single mandate of the ECB--price stability. French and German officials have expressed concern of an overvalued euro and are intent on forging a new "Bretton Woods" agreement to manage the dollar, euro and yen. And it is clear that the EU-11 face low cost competition in manufacturing in the rising economies of Eastern Europe, whose commitment to shadowing the euro is in doubt when recession looms.

Moreover, the EU-11 face competition from the UK, where structural adjustments were completed a decade ago and sterling is far from being anchored to the euro.

Scandinavia poses competitive pressures on the Union as well, not to mention the US and Asia.

Forced on the defensive, the ECB will be in no mood to cut rates or target the euro. Delaying rate cuts while the Fed continues easing and the "IPO-effect" assures an early euro overshoot.

Assuming the worldwide economic slowdown plants itself on the Continent by 1Q99, the delay in monetary accommodation and a strong currency will bring about a hard landing. Reactive monetary policy means greater amplitude in interest rate cycles.

While beginning its life as a strong currency, by late 2Q99 the euro will be weakening. It is at this point that pressure to stimulate on the fiscal side could threaten to upend the euro or, at the very least, pressure the weak (Italy) into an early exit for ERMII rehab.

While we are sceptical of a smooth start to the euro, we do not doubt its chances of survival given the political willpower of Germany and France to make it happen. However, one thing is certain--volatility in interest rates and the euro will be in evidence for the foreseeable future, providing plenty of trading opportunities to FX market participants.