Quantitative Easing or the Fed’s asset purchasing programs have almost vacuumed the market for long-term treasuries – at least those being available for purchases.
The Fed’s activities have lowered the yields of long-term treasuries down to a level most countries would envy them. Auctions of 30 years treasuries at yields below 3% are cheap funding – to say it at least.
There are so little of long-term treasuries available that the Fed for their latest monthly purchases has had to go into the market for mortgage backed securities.
And the programs looks to be continuing for months to come, which brings me to the question of whether a downgrading of US debt – should it happen - will have any impact on the borrowing cost for the US?
After all is it not likely that the Fed will just buy that debt and thereby just “hide” the true market impact such a downgrading otherwise would have had?
Euro strength is a puzzle to many. We have had weeks with worrying economic data causing forecast for a Euro-zone economic recovery to be delayed. We have seen Euro-zone confidence indexes peaking. We have had crisis in Cyprus setting possible precedence for bank deposits and credit regulations unheard of. We have had Italian elections where 6 weeks after they took place, the country still has no government. Still – the EURUSD is holding well. Any attempts to sell the pair lower meet support levels in tight layers and of substantial volume.
So what is it that prevents EURUSD from cracking down?
There are mainly two reasons:
1) For two of the major currencies – and those for which the EURO is an investment alternative – the currency printing machines go on full speed. Bank of Japan will increase their balance sheet by 45% throughout the rest of this year and for the Federal Reserve it looks to be an increase of 25%. What they do is to buy their own debt or those of mortgage holders and provide the market with cheap funding – cash at almost no cost. That the cost is low also means that the attraction is low. In addition – the cash is provided through printing of JPY and USD – which simply means that there will be lots more of currencies that already have low attraction. In reality it means that no one wants them.
2) USD used to be the reserve currency and the main asset class among currencies held by central banks and sovereign wealth funds. Three years ago many of those investors wanted to rebalance their currency portfolios with a lower weighting in USD and a higher weighting in other currencies – the EURO being one of the beneficiaries. Then we got the Euro-zone crisis and doubts to whether the Euro had a long-term future. Prudent as central banks and sovereign wealth funds are, the delayed their purchases of Euro and held on to the USD. But in reality this was just a delayed switch for which the three years that has passed has seen substantial purchases of Euro being put on hold until the uncertainty surrounding the currency became more clarified. Our estimate is that there is likely an interest to buy 500-750 billion Euros against USD – purchases that were meant for 2010-2013 but for reasons known to us all simply were not done.
While the Euro-zone has a long way to go before crisis are history, doubts about the currency’s future existence are likely pretty remote. In five years it might not be the same currency as it is today as some countries might leave. But if they do – the reborn currency is likely going to be one which is stronger and more solid than the one we have today. As such – for long-term investors like central banks and sovereign wealth funds – the confidence level missing throughout 2010-2013 – is likely back and I would think that these investors throughout the last 6 months have been among the silent bulls we seldom see but are there with a big long-term interest.
They are buying EURUSD which are not coming back to the market in a long time and likely not before Euro-zone economic problems and crisis are history and the EURUSD is well above 1.50. That might take a long time. But time is what these investors have a lot of. They are not stressed, they don’t chase the price but they are likely in on any dips for EURUSD of significance.
The sellers are the short-term bears who think that all the negative news for EURUSD cannot mean anything but a lower value. And they go short just to experience that the market absorbs their selling with no particularly falls for the pair. In the end they have to cover their shorts as the intended price impact did not materialize. And those shorts are covered from someone already being short and not from the ones who voluntarily bought the pair – hence the EURUSD goes up.
Bewildered? You shouldn’t be if 500-750 billion Euros are to be switched this way.
I have witnessed many financial crises throughout the last 35 years, in many parts of the world but never – anywhere – can I remember having seen depositors taking losses. That was before Cyprus last weekend.
My first reaction was – like everyone else – that this is too stupid, not really thought properly through and can set some serious precedence that can have grave financial consequences.
The new leader of the Euro group - Mr. Dijsselbloem - fuelled further head shaking this week when he indicated that the agreement for Cyprus possibly could set a norm for future bailout agreements. I mean - we all felt throughout his many years as Euro group leader that Mr. Juncker got pretty predictable. But what was this new guy up to?
But it also made me think, rethink and rethink again. Why did they do it and why is the new Euro group leader so keen to set an unheard of precedenc
His opening remark was that we should reduce the risk – which on surface looks obvious and always trigger the first question of how? On reflection it likely is a comment with deeper thoughts and from one who might have as an ambition to get to the root of the problem.
Let me take you back to the years when I was a Treasurer of a bank. Part of the balance sheet of a bank was always sovereign bonds. As a bank you were encouraged to buy it through lower capital requirement and liquidity requirements put on banks. To put all the technical details short, you were both encouraged and given incentives to pop up sovereign debt on the balance sheet of your bank.
Put yourself now in the shoes of governments from countries like Greece and Italy who prior to joining the Euro were used to borrowing cost exceeding 15% p.a. By joining up with the same currency as those stronger economies that had borrowing cost below 4% they saw the scope of having their own borrowing cost dramatically reduced – meaning that they could borrow even more and still have overall cost at a lower level.
Fine you might say – we know all of that and it is the source of the crisis within the Euro-zone. Yes it is – but it could only be done with a banking sector who willingly bought the debt.
So – authorities left them with the old incentives, regulations and capital requirements to do so – enabling banks to soak up all debt buyers like pension funds and life insurance companies did not buy. For them sovereign debt is a “natural” asset class. But for banks – is it really?
I think this is at the heart of the Euro group’s thinking. They want to get to the second root of the problem. Previously all focus was on the issuer of sovereign debt. Now they shift focus towards the buyers of such debt.
The European debt crisis has been rooted in two problems: one of countries issuing too much debt and one of banks buying too much of it. It explains why banks are the problem when too much public debt is a problem.
The first root to the problem has been addressed by the European Fiscal Compact, which when adhered to, will restrict further borrowing.
The second root to the problem was addressed last weekend when the main funding source for banks – their deposit base – became a risk asset class for deposit holders.
The consequences of what was agreed last weekend is that deposits becomes more of unpredictable funding for banks, which again means that for those banks with substantial assets in sovereign debt, they likely will see deposits disappearing, causing higher borrowing cost for them. This again makes it less interesting for them to sit on sovereign debt. Over time they will want to get rid of sovereign debt and over time sovereigns will have more problems finding buyers of their debt.
By addressing also this root of the problem, you get fewer buyers of sovereign debt making it more difficult to issue such debt.
Now – could the same have been done in a more elegant way and without threatening the old principle of deposits becoming risk assets for investors? Yes it could. The Euro group could have imposed restrictions or higher capital requirements, less of incentive and higher cost for banks holding sovereign debt. But that would have taken time and likely not given positive results as quickly as needed. Remember – we are in a situation of immediate crisis.
So they took the short cut which politicians often do: to shoot from your hips before thinking properly through all the consequences.
Some depositors will therefore suffer - those with deposits in Cypriot banks - but others will be spared over time as they will be cautious about where they put their money. The banks they will be looking for will be those with the smallest portfolios of sovereign debt on their balance sheet.
Banks will reduce such portfolios quickly as they otherwise will lose their deposit base. Mortgage holders should in theory not suffer through higher borrowing cost as any reduced deposit base for banks should be met by equal trimming of their portfolios of sovereign debt. From a liquidity point this is easy to do. But as banks lose a source of income from smaller balance sheets, mortgage holders might have to pay for the income shortfall. Only time will tell.
While being questionable in principle but definitively badly set out and therefore likely to cause a lot more fuzz - by defining deposits to be risky assets as the Euro group now has done, the end of the story might still be that the Euro area at last have got to grip with the two main sources for the debt crisis.
Ahead of today’s meeting, members of the FOMC should reflect on what they have obtained through the programs introduced in the fall of last year.
· New employment has risen but is still far short of a monthly figure of + 150 – 200 000 new jobs needed just to keep a stable ratio between those who work and those who don’t.
· Cheaper funding and lots of it looks to be invested in US stocks and new properties.
· The real economy is not picking up from the asset purchase programs as the broader range of macro figures at best can be seen to be stagnating.
So why do they do it and why do we expect them to do this in the amount of 1 trillion USD for 2013? I simply don’t know. An improving new housing market is good for the economy but higher US stocks are of little help. A weaker USD should help export but the effect has so far been marginal.
Maybe there is a good feeling factor the FOMC want to obtain from rising stocks and rising house prices? But if that is the only positive effect you obtain, the FOMC has created an asset bubble which – if the real economy is not improving - is bound to burst. So much they should have learned from history.
It puzzled me last week and it puzzles me even more this week. Euro-zone inflation is low (confirmed at 2.2% this morning), outlook for growth this year is pretty bad (Germany lowered their forecast this morning to 0.4% for this year), Italian and Spanish bond yields have come down significantly over the last 6 months while EURO has rocketed to a level where it starts hurting economies. So – what was the justification of a “no to rate cut” last week?
Reflecting on Mario Draghi’s press conference yesterday, it is clear to me that the ECB president is playing a very political role and that he possibly is the strongest confidence indicator we have in the market.
When asked about whether the decision on short-term rates was unanimous, he listed several improvements that has taken place over the last six months. They are facts – but no news as we know all of them. But by putting them together the way he does and the way he says it, it expresses confidence in a way that adds a new dimension to the details and as such it becomes a strong and EURO supportive statement.
He mentioned the confidence indices for the Euro-zone. What he did not mention is that these figures are very different among members – and it goes along the lines of those you can draw from debt problems. It is among the weaker economies that you need lower rates – not for Germany.
He mentioned that the balance sheet of the ECB is shrinking, which is of course because they don’t buy assets like they used to early in 2012. By the time they start doing this, it will increase again.
He also mentioned that the macros are weak, which is known. But as confidence indices almost always are ahead of macros, he assumes the macros to improve as well as he repeated they will in the 2nd half of this year.
The difference between him and markets is that markets always want to be ahead of the curve and therefore strengthen a currency before the figures support the strength. It is rather unusual that central bankers do the same. They normally wait for the figures to prove their point.
It is cleverly done if you want to show and give confidence. It is risky done if confidence indices again turn around.
The confidence factor Mr. Draghi expresses has substantial impact. Six months ago he said the ECB would do whatever would be needed to be done and if we were to believe him that will be enough. Six months later we know that they have had to do very little because the market adjusted most of what the ECB otherwise would have to do.
You play out confidence that way successfully and the market does the job for you.
It is politically clever and it has paid off. I am still unsure though whether this is the role of a central banker.
The good mood from yesterday might hang in for couple of sessions more and take EURUSD short-term even higher.
Medium-term I see no reasons to become more bullish from what he said. What he did was to trigger a move within what I have set out as a range and to give a boost to a market that had been a bit in limbo from the start of the year.
Well done Mario – or better – well played.
The 275 pips drop from the high Wednesday has caused all of those who 2 days ago wanted the EURUSD to sky rocket from 1.33 to turn around and now almost predict no bottom for the pair if it breaks below 1.30.
Well – good luck to them.
The market this week has been one for which short-term punters have been in – keen to get on with the new year, while the professionals have been skiing in St. Moritz, Courchevel and Aspen.
I have taken the approach that while 275 pips is significant over 2 days, whether or not this is a move to be extended or one to correct, is not to be properly put to test before next week.
We are back to the level we had before the festivity season and it might very well be that all that took place during the feast is to be forgotten – but again – we need those taking this period off - the pros - back on the pitch to see where EURUSD is heading.
It has been like this always – and with the news picture we have had this week, I am slightly sceptical to whether there has been anything else supporting the drop than short-term traders pissing in their trousers.
Today is jobs day in the US and prepare yourselves for more nervousness. It is Friday and it is a Friday thinner than usual. The volatility from a NFP figure today that surprises could be substantial. Whatever the outcome – the real reaction to today’s figures and all that has been going on over the last 2 weeks is up for judgement next week.