Significantly increased defense spending in Britain and Europe implies that a broader fiscal realignment could take place.
On Tuesday, the European Union announced $158 billion in loans to bolster defense spending and proposed activating a fiscal escape clause that would allow countries to spend $685 billion over the next four years on defense.
That is what is behind the rising equity valuations among European defense and industrial companies as well as the notable increase in the benchmark German 10-year yield on Tuesday to 2.48% and an appreciation in the euro to 1.05 against the dollar.
Before any realignment takes hold, though, Germany will first have to address its “debt brake,” a 2009 constitutional limit to federal borrowing to ensure balanced budgets.
That policy constraint will have to be lifted before any significant increase in defense outlays can be made or any joint debt can be issued in Europe, which is the ultimate outcome if a pan-European defense framework can be implemented.
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In addition, the possibility of higher U.S. tariffs and increased natural gas exports to Europe will continue to put downward pressure on the euro versus the dollar.
Given all of the factors pushing up the dollar, including Europe’s anemic growth, the wide yield differentials between the U.S. and German 10-year notes, and the coming of business-friendly economic policies in the U.S., it is premature to state that the euro is poised for sustained appreciation.
Perhaps talk of higher defense outlays will be sufficient to keep the euro from reaching parity with the dollar.
A look at EUR/USD implied volatility, a measurement of the price of options, or the volatility smile, strongly suggests that money on the table expects a weaker dollar versus the euro over the next month.
