How to solve the euro puzzle
Despite the worst crisis Europe has known since World War II, the euro stands at the same level against the dollar - at 1.25 - as in November 2008.
While investors have been calling for a weaker euro for much of the past two years as the sovereign crisis evolved, the single currency has held up relatively well, even appreciating versus the US dollar in the early months of this year.
One of the reasons for its resilience could lie in the overseas asset flows of European Monetary Financial Institutions (MFI). Indeed, the repatriation of overseas assets in times of stress for an overleveraged European banking system may have prevented substantial weakening of the currency - until very recently.
But what will happen next, given that forces at play oppose one another?
On the one hand, there are undeniable structural factors likely to ultimately weigh on the single currency. At the end of March, Greek overnight deposits were down 30% since June 2010. Around $30 billion has left Greek banks in less than two years.
During that same period of time, $119 billion exited the banking system of the Piigs bloc as a whole (Portugal, Ireland, Italy, Greece and Spain).
Runs on banks are typically the first symptoms of banking crises. Moreover, Piigs banks have massively increased their exposure to domestic government debt over the past year, whilst simultaneously decreasing their loans to the private sector.
So, while the total asset base remained flat, Piigs banks have actually degraded the quality of their balance sheets.
In effect, governments are buying their own debt through borrowing on the part of the very domestic banks they support. This type of scheme is not sustainable over the long-term, and at some point will impact the euro - in particular since it remains expensive versus most major currencies on a purchasing power parity basis.
On the other hand, given France's and Germany's very large exposure to the Piigs bloc (approximately €1 trillion), we expect massive policy responses from the European Central Bank (ECB), of a magnitude much greater than the two previous long-term refinancing operations (LTRO).
Indeed, with tax receipts of around €2 trillion compared to a €33 trillion European banking system, France and Germany do not have the firepower to shield, let alone rescue, financial institutions. The only player with sufficient ammunition to act is the ECB.
If it does so successfully, this would trigger transitory risk-on phases beneficial to the euro, especially in conjunction with continued repatriation of European banks' overseas assets.
Shorter term, while waiting for the ECB to intervene, we recommend protecting euro positions in portfolios. Such hedges can be temporarily unwound in the event of large and successful ECB interventions. Longer term, we still expect the euro to depreciate.
Stephanie Kretz is a member of the investment strategy team for private banking at Lombard Odier
This article was written for our sister website Money Observer