Written for First Post
December 10, 2011: As Europe hobbled to an agreement on deficits, the equity markets rallied but the currency and bond markets yawned. On Friday the US equity indices jumped by around 1.6%, the UK's FTSE 100 by a little less than 1% and the German Dax by 1.9%. The Euro however rose an anemic 0.31% against the US Dollar.

Equities tend to react prematurely and often out of proportion to events. Hence it's always good to take a look at the currency and bond markets to see if they confirm the optimism of the equity markets. The bond and currency markets are more mature and generally tend give a better picture of the long term.

So the fact that the Euro did not bounce as strongly as the equity markets after the news of the European agreement is not good news for the financial markets. Even against the other major currencies such as Yen and British Pound the Euro did not rally strongly after the news and in fact fell slightly against the Swiss Franc. The Euro-Yen pair rose 0.29%, the Euro-Pound rose 0.04% and the Euro-Swiss Franc fell 0.01%.

The rally in equities often shows that risk is back on the table, which should mean a strong fall in safe havens such as US Bonds. But the 30-year US treasury only fell 0.09% and the 10-year 0.08% on Friday. Hence we'd take the rally in equities with a pinch of salt. The reaction of the currency markets to the announcement makes sense. Under the agreement Euro-zone members with huge government deficits will face automatic penalties, and all governments will have some kind of laws to balance their budget. 

The currency markets shrugged off the announcement as these ideas have been floated before. Also UK a major player Europe vetoes key provisions of the agreement. There is a lot of distance the governments have to cover before the effects of the agreement crystallize. And again it remains to be seen if the political will exists to implement tough deficit reduction measures. 

The goal to reduce deficits sounds good on paper, but the markets know better. There are several ways to cut the deficit and many are not good. One way is to increase taxes to reduce deficits. This is the worst solution as higher taxes cut growth and in fact reduce tax receipts. Rising taxes is the easiest step for the political class and bureaucrats. Most often they rail that the rich or corporations don't pay their fair share  and then increase taxes. But corporations never pay taxes, they only pass it on to the consumer. And rich find ways to avoid taxes.

The second option that government uses to reduce deficit is cut government spending. This tends to be good in the long run, but hurts the economy in the short run. It is also difficult to implement in welfare states of Europe. Given Europe's socialist bias, the markets fear that political class will cut deficits by hiking taxes and doing very in little spending cuts. This will result in the slow decay of Europe just like in Japan and hence the currency and bond market's lukewarm response to deficit agreement.

The best way for Europe is to grow out of its deficit with pro-growth policies of lower taxes and less regulation. Lower taxes often increase economic output which in turn improves tax receipts even at lower rates. But the currency and bond market's feel Europe has gone too far left to correct and grow quickly.