German newspaper Handelsblatt Magazin hosts Josephine Witt in its cover.
German newspaper Handelsblatt Magazin hosts Josephine Witt in its cover.
When the ECB cut the deposit rate for a second time september 2014 to negative 0.20 from positive 0.10, the EURUSD price was located at about 1.3179 and at that juncture, it already broke the 5 and 10 year averages in the 1.3200 and 1.3300’s. December 2014, the EURUSD would travel further to break below the 14 and 16 year averages at 1.2550 and 1.2235. But january 2015 was the big month for the Euro as its descent would see every average break from 16 to 62 years. Viewed in this context, one would understand why the EURUSD lacked any meaningful correction.
The current EURUSD price trades around its 60 and 61.6 year averages at 1.1102 and 1.1119. Both averages encompass 720 and 740 months of data and dates to 1953. The EURUSD exchange rates are theoretical yet accurate because they were derived from Deutschmark exchange rates iterated from the XEU basket into ECU units. Not only is the 60 and 61 year averages resistance towards any EURUSD recovery higher but the 55 and 50 year averages are located at 1.1214 and 1.1372. Factor into the equation the historic mid point from the 1.5769 highs to the 0.6535 lows at 1.1152, the 1.1095 mid point of the 1st and 3rd quartile, the geometric mean at 1.0966, the 62 year median at 1.0863 and the EURUSD is in a massive downtrend that could possibly last for years. Its not necessarily a Fed Funds hike that would lend impetus to the downtrend although that would assist but the EURUSD from the 62 year perspective by itself is at its historic statistical price peak. Its not the averages alone, the EURUSD from a curve perspective is at the top of the peak.
For a currency price to break a 50 year average is quite unnatural in modern day currency markets and possibly a development rarely, if ever, seen historically. Editorially, a 50 year average break is my first experience and not seen in all my research and trading years. Typically in the best of volatile markets, currency prices trade between 1 and at the most 35 -40 year averages although 40 is quite a price stretch and extraordinary. What lends credence to such an historic break is the factor of the negative deposit rate which in itself is quite rare yet it was known and planned by the ECB based on an early 1900’s German economist by the name of Silvio Gesell, a German by name who resided in Argentina, retired in Switzerland, was ripped apart by Keynes in the General Theory but recognized and praised by Irving Fisher.
Under current account surpluses at Euro 20 billion february vs 19.5 billion january and 7.5 billion February 2014, the only manner for the ECB to experience a lower exchange rate was to go negative on the deposit rate since surpluses held the deposit rate in positive territory. If ever that rate approached negative, it was rescued by the ECB but the EURUSD price was also redeemed. By going negative, the ECB was able to channel money away from paying negative interest to banks excess reserves and force bank to bank lending in the private market. The negative deposit rate was the catalyst that saw the EURUSD crash through all its major averages in a 3473 pip run in 12 months and a break of its 10 month historic trend average. Factored as a whole, the trend however is only 7 months old or 167 days if calculated from the september interest rate drop and a 740 pip per year average drop since the 2008 crash factored from the 1.57 highs.
Not only is the lower exchange rate the target but economically GDP must be the first focus and not CPI. From a Keynesian perspective and viewed from the old IS/LM equilibrium Models, the antecedent to Taylor Rules, the lower the interest and exchange rate, the higher goes GDP as the equilibrium curve shifts. Since the september announcement to lower the deposit rate to negative, GDP has held steady between 0.2 and current 0.3 but hasn’t been negative since Q1 2013 yet 0.3 is consistent with its long run average at 0.35. Household expenditures contributed 0.2% Q4 2014 yet Spain and Germany were both the only contributing factors at 0.7 each and France 0.1 against the vast majority of negative for the remainder of European nations. Without Spain and Germany’s collaboration, GDP could’ve been much lower. Viewed annually, GDP 0.3 is well below its yearly growth rate of 0.9 yet barely above its historic mean since 2000. Since 2008, GDP annualized spent a vast majority of its life in negative territory.
Further, credit growth for march 2015 to residents was 0.4%, 0 previous and negative 0.2% annualized yet negative 0.5 february. The growth rate of short term deposits other than overnight deposits was negative 3.3% march 2015, negative 3.2% february
The focus on CPI as a factor of the lower exchange and interest rate lost its concentration as it was immobilized by the adoption of QE and a rising money supply. M1 increased 10% March 2015, up from 9.1% february but comprehensively M2 rose from 9.500,000 october 2014 to current 9,754,416. Overall, as money supplies rise, CPI remains depressed. The component contributing to the negative 0.1% annualized Inflation rate is rising commodity prices as food inflation rose to 0.3% from previous 0.1%. But Core Inflation has been negative since Q4 2014. Draghi’s recent press conference mention to take a harder look at CPI was articulated for good reason.
The recent central bank obsession with CPI is due to QE programs. Generally, as money supplies and velocities grow due from QE, CPI has a tendency to remain depressed. A gap is created between low CPI and money supply growth. Japan’s M2 money supplies and BOJ balance sheets has been rising on a beautiful trend line since 2008 but GDP growth rates ran 50 / 50 as 14 positive quarters were reported Vs 13 negative. Core Inflation was positive all 2014 but mostly negative since 2008. The BOE’s balance sheet as well as M2 has been rising since 2008 while Core Inflation dropped to 1% current since it peaked in 2011. M2 in the Eurozone resembles Japan as both rose on a skyrocket trend line while the ECB;s balance sheet dropped from 2012 but is heading hgher as QE progresses. The risk to Inflation Vs money supply growth is hyperinflation or deflation and is seen in the overall price level. One surprise tradgedy in the world can spiral prices out of control and resigns central banks to crisis management. Just as imporatant is the monitor of CPI due because QE is a new program and monetary policy has lags, generally 6 – 9 months. Within the confines of CPI and money velocity is found the work of Gesell.
The Euro and Europe had possibilities because to lower the deposit and exchange rate would provide a powerful economic base to produce terrific economic growth in the future despite the negative economic effects short term that would be seen in fundmamentals and yields. Prices, GDP, interest and exchange rates would all bottom and trend higher for many years but then the ECB acquiesced in the sledge hammer policy in QE. Where QE is seen predominately is in the deposit rate as rising money supplies depresses interest rates. This situation affirms cheap money.
The deposit rate or Eonia, Europe’s Overnight rate has been positive in only 29 of the last 167 days since september’s announcement to go negative and those 29 days were found in the beginning of september. Every average dating from 1 year to 1715 trading days or 7 years out and constructed based on 250 trading days for each average reveals not only a downward trend in its infancy but not one average of the 7 is overbought. Further averages from 20 to 100 days also reveals a trend in development and not overbought. Every target in each average ensures Eonia remains negative for a long time in the future. Median Lines as well for all averages affirms Eonia remains negative. For Eonia to turn positive from current -0.027, the 1 year average must break at 0.007. If money supplies rise and QE remains then Eonia continues as policy to affirm negative for longer.
For EURUSD, the next averages above the 50 year is the 45 year average at 1.1577, 40 year 1.1689, 35 year 1.1628, 30 year 1.1977 then 25 and 20 at 1.2253 and 1.2202. The most important point is the 50 year at 1.1372. A break in the opposite direction would be an important development however higher exchange rates is not what the ECB wishes nor is economics on track yet to warrant a higher exchange rate. The GDP target is predicated on a lower Euro but not a Euro that gets ahead of itself. A higher exchange rate is actually paradoxical to the current QE and negative interest rate policy. The targets are many and begin at 1.0703, 1.0513, 1.0326 then targets range from 0.9721 and 0.9791 to the lowest current points at 0.9372 and 0.9376. Despite a 3400 pip run over 12 months, the EUR is in quite a different location than has ever been known since 1998. For a major currency to run 3400 pips in 12 months is quite a statement.
The risks to a short Euro and the ECB strategy is the FED. Fed Funds effective at the last Fed meeting was 0.13 and rose from 0.10 since the last meeting. Before Yellen can raise, Fed Funds Effective must travel higher to an acceptable Fed level so the next raise is supported by a higher effective rate. The point at 0.13 just graduated to this new level april 13 to offer context. Possibly a hike comes when Fed Funds passes 0.15 and heads to near 0.20. Either way, the short EUR trade remains.
Greece still needs to find more than E1 billion in order to cover salary and pension payments it will face at the end of this month, an EU source has told MNI, after the cash-strapped government was forced to tap an emergency escrow account in order to meet a critical payment to the International Monetary Fund.
EU sources confirmed to MNI that Greece used a reserve account of Special Drawing Rights (SDR) to cover an E750 million IMF loan repayment due Tuesday. A Bank of Greece source said that the money in the account was available and unclaimed, and a last-minute solution was found to meet the IMF deadline. However, the funds need to be returned in a few weeks’ time.
“Greece right now has around E90 million only in reserves to pay wages and pensions in May,” which amount to around E1.2 billion, a senior EU source said.
“The quick fix of the SDR account just keeps the Greek government going without default but it now has to race against time to raise the money,” to meet its internal obligations. MNI reported Monday that the EU was getting increasingly worried whether Greece would made the payment after Prime Minister Alexis Tsipras informed the EU and the European Central Bank last week that he was unable to raise the amount.
High ranking EU sources have said that Commission President Jean-Claude Juncker and ECB President Mario Draghi were in constant contact with Athens to find the solution and that Draghi himself wanted to make sure that “things will stay in course.”
The government’s search for liquidity in lieu of the frozen E7.2 billion in bailout funds has included a drive to recover excess cash from local administrations and other public entities. As of Monday, the government said, its collected around E600 million, but a second senior Eurogroup source told MNI that any further cash collected raised from government organizations that haven’t handed in reserves would only cover a few more weeks of liquidity needs.
On Monday, while Eurogroup President Jeroen Dijsselbloem said he could not have a clear picture of the Greek liquidity situation, Finance Minister, Yiannis Varoufakis said “let’s not hide, liquidity is a terribly urgent issue.”
Both sources indicated that despite the positive statement on bailout talks by the Eurogroup Monday, key differences remain as neither side seems to be backing down from pension, labour and fiscal adjustments.
“The creditors will not back down because, first, the budget must be balanced which could mean further measures,” one official said. “Second, labour and pensions reforms are important,” he added, reiterating that there is still no clear picture on the Greek budget situation.
The second official commented that “both sides want a speedy solution, the climate in discussions is more positive and productive but no real breakthrough has been achieved.”
“We would wait to see in the following weeks, but so far as Mr Varoufakis said, the government remains firm to its position. But this is not possible,” the source said.
While some progress is said to be reached on issues such as non-performing loans on Greek bank balance sheets, privatizations and taxation, the talks could be stuck at any point when a difference of opinion emerges in the estimations of the fiscal situation, the sources said.
“Bigger gaps mean further measures,” the first source said wandering whether the Greek side will be able to accept it. “But liquidity is indeed running out so sooner or later we would have to come to a decision,” he added, mentioning that any extension of the programme is not realistic because it would mean that Greece will be able to cope through an extension without funds.
Sources have told MNI that if the two sides fail to agree in the next three weeks, the EU and the IMF are preparing a complete package proposal that will be presented to the Greek government with a “take-it-or-leave-it” ultimatum.
Greece’s banks hold enough eligible collateral to access an additional €14 billion in Emergency Liquidity Assistance funds, two Eurosystem sources have told MNI, suggesting that just weeks of increasing support remains for the country’s beleaguered financial system.
The total value of Greek banks’ eligible collateral after haircuts last week was about €93 billion, two Eurosystem sources confirmed, highlighting the limited scope for the ECB to further step up ELA support as political negations with the country’s international creditors drag on.
A return to the haircut schedule used late last year would shave €6 billion off post-haircut collateral, according to the sources, reducing it to about €87 billion and in turn limiting the scope for further ELA increases to just €8 billion.
The selloff in global bond markets over the past two weeks has investors wondering whether we have reached an inflection point in the extended period of ultra-low interest rates. With the Federal Open Market Committee (FOMC) creeping toward liftoff (still likely in September), eurozone inflation expectations stabilizing and the oil price creeping back up, it is tempting to argue that German 10-year yields near zero and U.S. yields below 2% were, in fact, overly stretched.
However, we remain skeptical of a sustained selloff at the long end of the yield curve. For one, coming out of a weak start to the year for the global economy, G4 monetary policy is poised to remain highly accommodative. Even at the vanguard in the U.S., the preconditions for Fed liftoff have not yet been met, and the FOMC is likely to emphasize that the upcoming pivot in policy will be gradual. Second, the market dynamics behind the recent upward repricing of inflation expectations will be tested as oil prices come under renewed pressure from stretched inventories. Finally, the fact that bond yields in the U.S. and Germany have tended to move in tandem in either direction (over the past month they have each increased by roughly 30 basis points) suggests that easy policy at the European Central Bank (ECB) will continue to weigh on U.S. rates once the current pullback abates.
That said, the selloff in bonds underscores the risk that fixed income markets will retreat hastily when the tide eventually turns. Our read of the moon phases is still at odds with an imminently rising tide, underpinning our modest duration overweight. We also note that at the short end of the yield curve the story is profoundly different. Even a relatively dovish denouement of the FOMC’s liftoff story is consistent with the front end of the yield curve selling off in the coming months, a flatter U.S .curve, and a re-firming of the dollar.
Running of the bond bulls. Bond yields across developed markets have shown a surprising sensitivity to economic data in recent weeks; surprising in the sense that there have not been any unambiguous indications of a broad-based acceleration in growth. Last week was no exception. More evidence emerged of first-quarter weakness in the U.S., and, while global output measures have not been as dour as GDP prints seem to suggest, global manufacturing output slowed in April.
Where the data does, in fact, suggest that the path of rates might be higher is in labor costs and inflation. In the U.S., lower productivity in the first quarter and rising compensation boosted unit labor costs, building on evidence from the Employment Cost Index that wages may be beginning to firm. Eurozone inflation data has also been slightly exceeding expectations, which has fuelled speculation about the expected length and intensity of the ECB’s quantitative easing program.
Signs of incipient inflationary pressure are also on display in market-based measures of inflation compensation. Five-year inflation expectations in five years time (5-year/5- year breakevens), the preferred measure of long-term inflation expectations at the Federal Reserve (Fed) and the ECB, hit 2015 highs last week at 2.25% and 1.82%, respectively.
An integral driver of the rise in inflation expectations is the recovery in oil prices. Brent and West Texas Intermediate (WTI) crude, at about USD 65 and USD 60 per barrel, respectively, are substantially higher than their troughs in January and March, flying in the face of a looming oil inventory glut and U.S. storage capacity reaching stressed levels. Petroleum data last week from the U.S. Energy Information Administration showed the first drawdown of inventories since the beginning of the year; however, the general trends of flat production and highly constrained exports remain intact.
The timing of oil price moves and the repricing of inflation expectations suggest that the two are closely related. The acceleration in crude oil price declines in October 2014 took place in tandem with the sharp drop in 5-year/5-year inflation breakevens. Symmetrically, the rebound in U.S. and eurozone inflation compensation that began at the end of April followed on the coattails of a bounce in WTI and Brent prices. If we are currently at the top end of the range for oil prices in the coming months, as many analysts posit, inflation expectations may well backtrack as this process goes into reverse.
Spillovers and automatic stabilizers. Even though labor market tightness and oil prices are not screaming that inflation will be higher in the near term, we are cognizant of the possible fallout from higher inflation expectations and benchmark rates. Given the low levels they were coming off, the percentage changes in European bond prices have been dramatic. In Spain and Italy, for example, the weekly price declines are on par with or lower than those in the depths of the eurozone sovereign debt crisis. Moves of this magnitude may also give rise to broader spillovers throughout portfolios as negative sentiment spreads to credit or investors cap losses in sovereign debt.
One force for stabilization is the response of monetary policy to higher rates. Were bond yields to continue to rise and begin to feed into tighter financial conditions, the implied path of policy rates in the coming years would implicitly become more shallow. That is, the FOMC would commit to an even more gradual path for the Fed Funds rate and the ECB might extend or even redouble its efforts. Lest we forget, the Fed also has a USD 4 trillion dollar balance sheet that will continue to weigh on long-term rates. An uptick in U.S. oil supply is an additional stabilizer that could emerge from the bounce in crude prices.
In sum, a common thread behind the backup in bond yields appears to be a repricing of inflation. The rebound in crude oil prices, an upswing in inflation compensation, and emerging signs of labor market tightness have sparked concerns that bond yields must rise. While we agree with the general prognosis—that rates are well below where they should be in the medium term—inflation will take some time to normalize from the current exceptionally low levels. That, and a likely dip in oil prices, suggests that bond yields are running ahead of themselves.
Our Chart of the week shows the ascent of 10-year U.S. Treasury and German Bund yields since the beginning of April. The inflection points for both series towards the end of the month followed turning points in market-based measures of inflation expectations. A continuation of soft economic data or another dip in the oil price may quite possibly temper enthusiasm on inflation, which could moderate or even reverse this process.
Sources: Bloomberg, daily data, as at 7 May 2015