Confusion Prevailed

In Europe confusion prevailed
As once again countries there failed
To work out the rules
For bank-closing tools
Which were to have just been unveiled

On the whole, the dollar continues to gain, with only a few minor currencies able to rally as we begin the week.  The notable stories over the weekend were the failure by the EU to come up with a bank resolution mechanism to sever the connection between weak banks and the their national debt problems and the ongoing tightness of Chinese money markets, where the PBoC is trying to rein in ultra loose credit without causing a bank failure or two.

Let’s look at the EU situation to start.  One of the key problems driving the Euro area crisis has been the fact that the peripheral nation’s sovereign debt has largely been held by domestic banks, so Spanish banks own Spain’s debt and Italian banks own Italy’s debt, etc.  That’s all fine and well until the nation’s creditworthiness is called into question.  At that point, the holders of that debt (the banks) are also under the gun.   Given the incestuous relationship between bank and country, problems get multiplied as the viability of the banks is called into question alongside the viability of the nation.  The EU has been trying to address this issue for two years, and last year they ‘agreed’ to a resolution mechanism in one of their meetings with the details to be worked out later.  The idea was that there would be a pan-European entity (under the auspices of the ECB) which would be funded by the members of the Eurozone and would be able to directly recapitalize failing banks.  This would prevent the individual countries from having to take on more debt to save their banks, thus preserving their own creditworthiness.  This all sounded great in principal.  Alas, at the meeting this weekend to hammer out the details, they could not agree on a formula for allocating risk.  In other words, the nations that have to fund this idea (Germany, Austria, Finland and the Netherlands) are not keen to have their taxpayers own bank shares in places like Spain and Italy.  Of course the Spanish and Italians are very keen for others to take that risk.  While it would not be a surprise that, eventually,  European leaders took on this risk despite what could happen to their citizens, it would be a surprise if it were to occur before the German elections in September, as that would open Chancellor Merkel to substantial attacks from her opponents.   And so, despite assurances that they will resolve this issue at yet another meeting this Thursday, I doubt they will reach anything other than a weak compromise with no commitments by the players who matter, although they will describe it as the solution to all their problems.  This is simply another facet of my underlying bearishness on the single currency, the inherent structural flaws in its design.  And while the euro has edged lower overnight, it remains relatively well bid, at least compared to most other European currencies.

I believe the euro’s relative bid is a result of continued unwinding of trades where investors had used the euro as a funding currency to purchase emerging market currencies and assets.  This is exactly analogous to the yen’s behavior in the wake of the financial crisis in 2008.  Back then, the yen was the key funding currency (remember, only they had zero interest rates at the time) and so short-term investors borrowed yen and used the funds to buy other assets.  This was the carry trade, and it was established in very large size.  When things went south after the Lehman bankruptcy, these positions were liquidated very quickly, which resulted in lots of yen buying, and a much stronger yen1.  I think we are seeing the same thing happen in the euro, although not to the same extent, as the euro had been a popular funding currency for many emerging market trades.  As those trades get unwound, the investor needs to buy euros to repay the funding.  Hence, the euro’s resilience in the face of USD strength elsewhere.  German data was benign, with IFO as expected at 105.9, and I believe all eyes remain on the Fed for now.  I maintain my view that the euro will continue lower over time.

Now, quickly, on to China.  The PBoC is trying to hold the line against the massive real estate speculation that has been occurring in the country, as well as limit the shadow banking system.  However they don’t have the same array of tools to adjust policy that we see in the developed world.  In addition, as there is no semblance of independence, it is widely expected that they will implement whatever policy the government chooses, rather than simply address the monetary concerns in country.  As such, recent gyrations in the short term funding market have been extreme.  A combination of increased demand for funds because of maturing debt and savings withdrawals because of the recent Chinese holidays forced many banks to pay up to fund themselves driving the overnight and 7-day repo rates to records late last week.  While those rates have since fallen, they remain well above recent averages and continue to exhibit a real tightness in markets.  It is becoming clear that the Chinese government is prepared to accept slower growth in order to prevent the inflation of a significant real estate bubble, and that does not bode well for the many exporting nations who rely on China as a key market.  So Chinese monetary foibles are displayed via a much weaker AUD and NZD, both of which count China as their number one export destination.  So too, KRW, MYR and, in fact, the rest of the Asian currency world.  The weakness across all these currencies has further to run.

There is no significant US data today, so we will look at data tomorrow.  Futures are pointing lower and Treasuries are continuing their rout.  (3% in the 10 years anyone?)  I see no reason for those trends to change, nor for the dollar to show any weakness in the near term.  Receivables hedgers, the pressure is continuing and will do so for the rest of the summer at least.

Good luck

1 – This was the genesis of the idea that the yen was a safe haven.  The fact that the yen rallied alongside the dollar as investors fled their carry trades has been confused into a causality.  People weren’t buying yen because they felt it was safe, they were buying yen because they had to repay their debts.  However, the correlation was extremely high, and so many believed the story.  To be clear, yen is NOT a safe haven!

2 thoughts on “Confusion Prevailed

    • Thanks Keith. I hope you’re ready for a bigger equity and bond market decline than we have seen, I fear this is just getting started. The market is about to reprice QE out of the picture. That is what we have seen and there is more to come.

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