March: ECB’s painful month?

As you know, the Euro has been massively under pressure since the ECB’s May meeting last year and decreased from 1.40 to a low of 1.11 before edging back to 1.14. In my article The Euro Strength and The ECB’s options, I explained the ‘Euro strength story’ (July 2012 – May 2014) by the following three factors:

  • Narrowing peripheral-core spreads (After Draghi’s ‘Whatever it takes’ and OMT introduction)
  • Divergence between the ECB and the Fed’s balance sheet total assets
  • Current Account back into positive territories

During this ‘prosperous’ period, nothing was able to stop the Euro despite poor fundamentals (i.e. flat growth, high unemployment rate and declining inflation). Then, Draghi’s promise ‘the Council is comfortable with acting in June’ completely broke the upside trend and the market has been totally relying on the ECB’s balance sheet expansion plan. It is clear now that EZ policymakers’ goal is to see the central bank’s balance sheet expend by 1.14tr Euros within the next 18 months and reach June 2012 levels (approximately 3.1tr Euros). As you can see it on the graph below (EURUSD monthly chart), the market got really excited about this news and traders and investors have completely switch to a bearish view when it comes to EURUSD (and EURGBP). We saw that Bulge Bracket banks reviewed their EURUSD forecasts for 2015. Sell-side research predicts a EURUSD between 0.90 and 1.00 within the next 6 to 12 months. Moreover, if we have a quick look at the last CFTC’s Commitments of Traders report, ‘net speculative’ positions were approximately -186,000 in the week ending February 17, and are closely approaching June 2012 low of -215,000.

Screen Shot 02-23-15 at 12.44 AM

(Source: Oanda, CoT)

If you ask me where I see EURUSD in the long term, there is no doubt that my answer is ‘South’. With the Fed considering starting its monetary policy tightening cycle (June meeting for a first 25bps shift probably), monetary policy divergence will weigh on the currency pair in the LT and parity looks like a reasonable level to me. In addition, Grexit contagion effect to ‘scarier’ countries such as Spain could also trigger another episode of peripheral-core yield spread divergence and therefore add more selling pressure on the single currency.

However, I think that traders and investors should be careful at the moment. Over the past two weeks, volatility has dropped in the market and EURUSD has been trading within a tight 180-range (1.1270 – 1.1450). Based on the last discussions I had, some of the traders were clearly waiting for a breakout ahead of the Greek deal, therefore the 1.1270 support was carefully watched on Friday (this is the reason why I put my take profit slightly above at 1.1300, see article Pocketful of Miracles). However, the Euro looks resilient based on current market conditions and I have to admit that I see potential Euro strength in the month coming ahead. As you can see it below, EURUSD reached a 11-year low at the end of last month at 1.11 before coming back to 1.14. The Fibonacci retracements were built based on October 200 low of 0.8230 and July 2008 high of 1.6040 range. Unless contagion risk spreads to other EZ countries (i.e. higher core-peripheral risk), the bullish trend could last for a month or two (based on previous bull consolidation after sharp sell-off).

Screen Shot 02-23-15 at 12.50 AM

(Source: FXCM)

The ECB bond buying program: Ambitious plan, disappointing results?

We are aware now that the ECB has announced a round of measures in order to counter the deflationary cycle (inflation rate of -0.6% in January) and of course support investment and consumption, the two key contributors of the 19-nation economy. The last one was of course the January announcement of additional purchases (combined monthly asset purchases of 60bn Euros from March to September 2016). This programs involves private assets such as covered bonds (safe form of debt issued by banks), ABS and public debt (bonds of national government and European institutions). However, unlike the Fed, the ECB will have to seek them in the secondary market; in other words, find the banks that will sell them these bonds. And Draghi’s (and Co.) problem here is that the ECB may face unwilling sellers. As some of you know, banks’ treasury desks usually buy short-term bonds and use government debt as a liquidity buffer: regulators require banks to hold high-quality liquid assets – HQLAs – against future cash outflows in periods of market stress. As some of you may know, most bonds issued by banks are excluded as they may prove illiquid during a financial crisis; however, the eligibility requirements imposed on government bonds look loose. Therefore, this implies that that government bonds currently represent a considerable portion of bank assets.

In the European Union, there are two new ratios:

  • Liquidity Coverage Ratio LCR, requiring banks to hold a stock of liquid assets for an amount covering the net liquidity outflows which might be experienced, under stressed condition, over the following 30 days,
  • Net Stable Funding Ratio (NFSR), which requires that the amount of available stable funding (i.e. portion of capital and liabilities expected to be reliable over a one-year time horizon) should be at least equal to the required amount of stable funding or the matching assets (i.e. illiquid assets which cannot be easily turned into cash over the following 12 months).

These two ratios were enacted through a Capital Requirements Directive (CDR4) and Regulation (CRR) issued in June 2013. Based on the Basel 3 documents, liquid assets in the LCR should mainly consists of:

  • Cash
  • Central bank reserves (including required reserves)
  • Marketable securities representing claims on or guaranteed by sovereign, central banks, PSEs, BIS, IMF, the ECB and European Community, or multilateral development banks
  • Bonds issued by non-financial firms and covered bonds with a rating at least equal to AA, subject to a 15% haircut and a 40% concentration limit

The two questions now that comes to my mind are:

  1. Who will sell those bonds to the ECB?
  2. Suppose the ECB offers good prices (i.e. good realized PnL for bond trading desks), what will traders do with this new cash with a deposit rate now at -0.2%?

Disappointing ECB could lead to Euro strength…

To conclude, I think there is potential risk that the ECB disappoints the market in March based on their purchases as the central bank won’t find the liquidity in the market. In my opinion, this scenario could play in favor of the single currency. My point is that we may see a bull consolidation before reaching the parity level that everyone seems to be talking about. The next couple of resistances to watch on the topside would be at 1.1530 and 1.1680.

Pocketful of Miracles…

It is sure that things are not easy negotiating with its ‘partners’ as time goes on. As Latin poet Publilius Syrus once said ‘A small debt produces a debtor; a large one, an enemy’. I am now interested to see where the negotiations will go within the next few days.

First, let’s review quickly what is going on with Greek’s liabilities.

GreekDebt

(Source: Bloomberg)

The pie chart above shows us who ‘owns’ Greece’s public debt. According to the country’s Statistical Authority, Greece’s total public debt amounted €315.5bn  at the end of the third quarter of last year, which corresponds to roughly 180% as a share of the country’s GDP. As you can see it, the EFSF, the EZ temporary crisis-fighting fund, lent the country €141.8bn (which represents 45% of it) and the current weighted average maturity is 32.38 years with the last payment due in August 2053 according to the fund’s website. As you may have heard at the end of last year, the Board of Directors of the EFSF decided to grant Greece a two-month technical extension. The program will end on February 28th instead of December 31st last year. As a result, the remaining amount available (1.8bn Euros, which will raise the total amount to 143.6bn Euros) could still be disbursed to Greece (in need of assistance) until the end of this month.

Another major ‘creditor’ of Greek’s debt is the ECB, as a result of the Security Markets Programme (SMP), which currently owns about €27bn (i.e. represents 40% of the €67.5bn marketable debt outstanding). However, whereas EFSF loans where principal payments don’t start until 2023, Greek is set to pay 6.7bn Euros held to the ECB this summer (20 July: €3.5bn, 20 August: €3.2bn).

Eventually, the IMF is also an important creditor with 25 billion Euros according to the fund’s website, maturing currently. IMF loans in February and March are €3.5bn. As a reminder, the IMF’s policy is to never restructure its loan.

Therefore, if we add up the Greek Loan Facility (Bilateral Loans), the ECB holdings, the EFSF loans and the outstanding IMF credit, we get 246.7bn Euros, that is to say 78.2% of the total public debt. How convincing will the new Tsipras government be ‘against’ those figures?

It has been a rough start for Greece: the country’s news has been making the headlines since (and before) the election of the new government (January 25th). PM Tsipras has made it clear that Greek debt is unsustainable, condemning the country to a state of perpetual economic recession and deflation, and is trying to negotiate a write off with its debt creditors. In addition to that, he unveiled last Sunday plans to undo several austerity measures: gradually increasing the minimum wage, dropping the recent property tax and promised the retirement age wouldn’t be change (anymore).

However, this will be the tricky part of the deal – asking for a write off while easing austerity measures – as they don’t (or never) come together usually. Negotiate a debt write off, press for a relaxation of economic austerity, avoid a bank run, and on the top of that, maintain a political stability. It is interesting to see that investors are considering political risks once again after more than two years of main attention to the ECB and its programs and promises.

However, as many of you, I would agree that the market is underestimating the consequences of a Grexit clearly, not only the costs, but also contagion to other ‘weak’ peripheral economies (i.e. Portugal). What would happen to the Euro if the spread between peripheral and core yields (good sovereign risk indicator) starts to rise once again (like in early 2012)?

Quick view on EURUSD:

EURUSD broke its small resistance at 1.1350 yesterday after a quiet week, and seems on its way to retest the 1.1500 level. We saw earlier this morning that EZ grew by 0.3% in the last quarter of 2014, meaning that the 19-bloc economy grew by 0.9% during 2014, better than the 0.8% expected (see details in Appendix). However, Greek FinMin is making the headlines this morning: ‘Haircut preferable to loan extension’, which is obviously ‘capping the pair on the topside. A good entry level would be above 1.1460 (if it makes it up there), with a stop above for 1.1530 and a take profit at 1.1300. You can also play the bigger range, setting your stop above 1.1650 and take profit at 1.1200. However, I wouldn’t recommend to be too ‘greedy’ ahead of the Eurogroup meeting on Monday.

Otherwise, I stay strongly bearish on the Euro in the long term (vs. USD and GBP), as growth, monetary policy divergence, Grexit contagion, geopolitical tensions will clearly weigh on the single currency.

Appendix

EZGDP

(Source: EuroStat)

January 2015: A Rough Start

The past month has been quite eventful in the financial market and I am sure that some of the decisions (if not all) surprised many of us. After the SNB announce on January 15th, the ECB took over and unveiled a €60bn monthly QE (not open-ended) through September 2016; so 19 months at €60bn equals €1.14tr. The ECB, which has already been buying private assets such as covered bonds (a safe form of debt issued by banks) and ABS, will add an additional €50bn worth of public debt (bonds of national government and European institutions) to its current program starting in March this year. The purchases of these securities (in the secondary market) will be based on the Eurosystem NCB’s shares in the ECB’s capital.
In addition, President Draghi also added that the ECB will remove the 10bp spread on the TLTROs, and the interest rate applied will be equal to the rate on the Eurosystem’s MRO (5bp).

We saw on Friday that EZ preliminary inflation fell by 0.6% in January after a -0.2% print in December, the largest decline since July 2009 when prices also fell 0.6% following GFC.

The ECB decision(s) sent the Euro to newest lows last week, down to 1.1120 (11-year lows) against the greenback and below the 0.75 level (0.7440) against the pound. But more importantly, it sent a bigger amount of government debt in the negative territory (yields). According to JP Morgan, there is currently (approximately) €1.5tr of Euro area government bond with longer than 1-year maturity trading at negative yields over time, and a ‘mind-blowing’ €3.6tr of global government bond debt (nearly a fifth of the total) with negative yields as the chat below shows us. For instance, the entire 10-year Swiss curve is  now negative.

Global NIRP(Source: JPMorgan)

Another interesting topic is of course the 3 consecutive rate cuts (in 10 days) by the Danish Central Bank, that lowered it deposit rate to a record low of -0.5% to defend its peg and keep the Danish kroner (DKK) close to 7.46 per Euro (ERM II since 1999). EURDKK went down below 7.43; we will see this week how much policymakers spent in January in order to counter a DKK appreciation (some reports estimated that the central bank had to sell more than DKK 100bn). As a consequence (of the NIRP policy), a local bank – Nordea Kredit – is now offering a mortgage with a negative interest rate.
I believe the Danish krone is a currency to watch (in addition to the CHF) this month if the situation in Greece deteriorates.

A Weak Swiss Franc…
Since the SNB surprise, the Swiss has remained weak against the major currencies, with USDCHF up 7 figures  (trading currently at 0.93) and EURCHF up from parity to 1.0550. Analysts slashed their forecast for this year and are now predicting a recession (-0.5% according to the KOF Swiss Economic Institute). I like the chart below which shows the 12-month Probability of the top 10 countries to fall into recession in the coming months according to Bloomberg economist surveys.

Probarecession(Source: Bloomberg)

Japan and JPY still under threat over the long-run
In Japan, the 10-year JGB yield rose by 9bp in the last 10 days and is now trading at 29bps. USDJPY tumbled below 117 overnight on Grexit comments and Chinese manufacturing PMI contraction in January (49.8 vs. 50.2 expected), breaking its 117.25 support and extending its trading range to 116 – 118.75. ‘Buyers on dips’ reversed the trend and the pair is now trading at 117.60.
If we look at the long-run perspective in Japan, late macro indicators showed us that Abe’s government will have to do more. Real wages are still declining and fell the most in almost 5 years and the economy has now entered in a triple-dip recession (0.5% contraction QoQ in Q3). On the top of that, inflation has been weakening for the past 8 months as energy prices (mainly weak crude oil) weight on Japanese core inflation rate.
In addition, we saw that Japan plans a record budget deficit for next fiscal year (starting April 1st 2015) to support the economy. FinMin Taro Aso reported that government minister and the ruling coalition parties approved a 96.34tr Yen budget proposal for FY2015/2016. And I believe that we haven’t reached the peak yet, as Japan’s aging population (i.e. increasing social security spending) will ‘force’ the government to print larger and larger deficits. The IMF predicts that the country’s debt-to-GDP ratio will increase to 245% in 2015. It clearly shows that the USDJPY trend is not over yet, and there is further JPY weakness (and USD strength) to come.

On the other side of the Pacific Ocean, the US economy cooled in the fourth quarter. After the 5-percent Q3 print, GDP expanded at a 2.6% annual pace in the fourth quarter (first estimate). Net exports was the largest detractor from Q4 GDP (-1.02%) as imports grew faster than exports. King Dollar continues to benefit from the global weakness with the USD index trading slightly below 95. The equity market still handles the Fed’s withdrawal from the Bond Market with the S&P500 trading around 2,000 (looks like it is out of energy though), while US Treasury yields are compressing to new lows. The 10-year and the 30-year yields are trading at 1.67% and 2.25% respectively (which is quite concerning), and it seems the trend is not over yet. In regards to the inflation rate (that plummeted to 0.8% in December), the Fed delivered a hawkish statement last Wednesday (‘strong jobs gains’, ‘solid pace’ for economy), however dropping the entire ‘considerable time’ sentence and adding ‘inflation is anticipating to decline further in the near term’. The implied rate of the December 2015 Fed Funds futures contract is trading 30bps lower at 41 bps, while the December 2016 implied rate decreased by 60bps to 1.05bps in the past 6 weeks.

An important topic to follow this month will be developments in Greece which are moving very fast since the election on Sunday (January 25) and Syriza’s victory. ECB council Member Erkki Liikanen said over the week end that Greece needs to negotiate a deal before February 28th (when the Greek support program EFSF expires after the 2-month extension approved in December).