Random Thoughts July 9

a) The ECB has published a document called 'The international role of the Euro'. One article focuses on the private use of the euro as a parallel currency in non-Eurozone countries. It finds that during 2008 especially in Central Eastern Europe as well as in Southern Europe holdings of Euro banknotes increased. "Evidence from a number of sources suggest that euro banknotes are increasingly used in countries east of the EU, mainly as a store of value and for large transactions." Furthermore: "Around EUR95 billion worth of euro banknotes were estimated to be in circulation outside the euro area at the end of Deccember 2008, around 13% of the euro banknotes in circulation for that reference month." This is up from 71.1 billion at the end of 2007.
To me one sign of a potential upcoming currency crisis is that domestics lose faith in their own currency and divert their assets into another currency while starting to use foreign currency for daily transactions. This leads to a lower demand for the home currency with likely inflationary consequences. On the other side, it increases demand for the foreign currency (in this case the Euro) which might well add to already existing disinflationary consequences.

b) Risky assets have moved signficantly lower since the start of the month and the larger equity indices have lost approx. 10% from their late May highs. However, commodities - especially energy - has been hit even harder. The chart below shows the CRB-Index since the start of the year. Between late February and mid June, the CRB gained 33% but is now up only 15.5% (so it lost half its previous gains). Equities on the other side, have gained more during their spring rally and lost less so far in the current correction.
To me this confirms that the end demand for commodities is weak (as it should be given the world-wide recession) and that a lot of the run-up in prices has been down to stockpiling and speuclation. However, especially stockpiling can not go on forever as it is costly to hold physical commodities and the capacity to do so are limited. Furthermore, the recent sell-off in broader commodity indices confirms also that inflation is not around the corner and a 'flight' into real assets amid inflation and sovereign default worries carries substantial risks as well. However, this should not be so surprising given that we have a destruction of real demand and an oversupply in several real assets (most notably housing): Too little money chasing too many goods!