In Europe, despite what you’ve heard
The rebound could well be deferred
The ECB told
The banks there to hold
More capital lest they’re interred

It seems that the ECB is still a bit concerned about the future of the Eurozone economy.  Perhaps it was the news that the Unemployment rate in Spain jumped up to 15.3%.  Or perhaps it was the news that cases of Covid are growing again in various hot spots across the Continent.  But whatever the reason, the ECB has just informed the Eurozone banking community that dividends are taboo, at least for the rest of 2020, and that they need to continue to bolster their capital ratios.  Now, granted, European banks have been having a difficult time for many years as the fallout from Negative interest rates has been accumulating each year.  So, not only have lending spreads shrunk, but given the Eurozone economy has been so slothful for so long, the opportunities for those banks to lend and earn even that spread have been reduced.  It should be no surprise that the banking community there is in difficult shape.

However, from the banks’ perspective, this is a major problem.  Their equity performance has been dismal, and cutting dividends is not about to help them.  So, the cost of raising more capital continues to rise while the potential profit in the business continues to fall.  This strikes me as a losing proposition, and one that is likely to lead to another wave of European bank mergers.  Do not be surprised if, in a few years, each major country in Europe has only two significant banks, and both are partly owned by the state.  Banking is no longer a private industry, but over the course of the past decade, since the GFC, has become a utility.  But unlike utilities that make a solid return on capital and are known for their steady dividend payouts, these are going to be owned and directed by the state, with any profits going back to the state.  I foresee the conservatorship model the US Treasury used for FNMA and FHLMC as the future of European banking.

The reason I bring this up is because amidst all the cooing about how the EU has finally changed the trajectory of Europe with their groundbreaking Pandemic relief package, and how this will establish the opportunity for the euro to become the world’s favored reserve currency, there are still many fundamental flaws in Europe, and specifically in the Eurozone, which will effectively prevent this from happening.  In fact, there was a recent study by Invesco Ltd, that showed central banks around the world expect to increase their reserve allocation to USD in the next year, not reduce those allocations.  This has been a key plank for the dollar bears, the idea that the world will no longer want dollars as a reserve asset.  Whatever one thinks about the US banking community and whether they serve a valuable purpose properly, the one truth is that they are basically the strongest banks in the world from a capital perspective.  And in the current environment, no country can be dominant without a strong banking sector.

In fact, this may be the strongest argument for the dollar to remain overpriced compared to all those econometric models that focus on the current account and trade flows.  A quick look at China’s banks shows they are likely all insolvent, with massive amounts of unreported, but uncollectable loans outstanding.  China has been the most active user of the extend and pretend model, rolling loans over to insolvent state companies in order to make it appear those loans will eventually be repaid.  Only US banks have the ability to write off significant amounts of their loan portfolio (remember, in Q2 the number was $38 billion) and remain viable and active institutions.  In fact, this is one of the main reasons the US economy has outperformed Europe for the past decade.  Covid or no, European banks will continue to drag the European economy down, mark my words.  And with that, the euro’s opportunity for significant gains will be limited.

But that is a much longer-term view.  Let us look at today’s markets now.  If pressed, I would describe them as ever so slightly risk-off, but the evidence is not that convincing.  Equity markets in around the world have been mixed, with few being able to follow the US markets continued strength.  For example, last night saw the Nikkei (-0.25%) slide along with Sydney (-0.4%) while both Shanghai and the Hang Seng rallied a solid 0.7%.  Europe, on the other hand has much more red than green, with the DAX (-0.35%) and CAC (-0.75%) leading the way, although Spain’s IBEX (+0.3%) seems to be rebounding from yesterday’s losses despite the employment data.  Meanwhile US futures, which were essentially unchanged all evening, have just turned modestly lower.

The bond market, though, is a little out of kilter with the stock market, as yields throughout Europe have moved higher despite the stock market performances there.  Meanwhile, Treasury yields are a half basis point lower than yesterday’s close, although yesterday saw the 10-year yield rise 4bps as risk fears diminished.  Gold and silver are consolidating this morning, with the former down 0.85% as I type, and the latter down 5.0%.  But in the overnight session, gold did trade to a new all-time high, at $1981/oz.  The rally in gold has been extremely impressive this year, and after touching new highs, there are now a few analysts who are growing concerned a correction is imminent.  From a trading perspective, that certainly makes sense, but in the end, the underlying story remains quite positive, and is likely to do so as long as central banks believe it is their duty to print as much money as they can as quickly as they can.

As to the dollar, it is broadly firmer this morning, although the movement has not been that impressive.  In the G10, kiwi is the biggest loser, down 0.5%, as talk of additional QE is heating up there.  But other than SEK (-0.4%), the rest of the block is just a bit softer, with CHF and JPY actually 0.1% firmer at this time.  Emerging market activity shows RUB (-0.8%) as the weakest of the lot, although we are also seeing softness in TRY and ZAR (-0.6% each) and MXN (-0.5%).  Softening oil and commodity prices are clearly not helping either the rand or peso, but as to TRY, it remains unclear what is driving it these days.

On the data front, yesterday saw Durable Goods print largely as expected, showing the initial bounce in the economy.  This morning brings Case Shiller Home Prices (exp 4.05%) and Consumer Confidence (95.0), neither of which seems likely to move the needle.  With the Fed on tap for tomorrow, despite the fact they are likely to leave well enough alone, there will be much ink spilled over the meeting.

In the end, the short-term trend remains for the dollar to soften further, today notwithstanding, but I don’t believe in the dollar collapse theory.  As such, receivables hedgers should really be looking for places to step in and add to your programs.

Good luck and stay safe

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