Has Voldemort fallen out of love with the euro?

Macro Man is still struggling to pick his jaw up off the floor this morning, still attempting to come to grips with what he saw over the long bank holiday weekend. You see, for the first time since John Major was PM, the UK enjoyed a sunny and warm May bank holiday weekend. Not that such beautiful weather is without demerits, however; not only did Macro Man get stick from Mrs. Macro for allowing Macro Boy the elder to get sunburned playing football sans shirt yesterday, but he'll now have the memory of last weekend thrown in his face when he dares complain about UK weather when it's 55 degrees and rainy on the 4th of July. Ah, the crosses we must bear....

In any event, recent price action in currencies has been instructive. The dollar has tried to sell off this week, led in part by record high oil prices and a rebound in gold that will no doubt delight the tin-foil hat brigade. However, the euro rally above 1.55 has been met by reported sales from Asian central banks, a theme that's been ongoing for the last week or two. Now, what's peculiar is that the euro was essentially frog-marched up to 1.60 by central bank demand....but since then has been sold off aggressively, with some of the same names that had previously been buying cited as the sellers. This has led Macro Man and others to speculate: has Voldemort (and others) fallen out of love with the euro?
What's beyond dispute is that something has changed chez Voldy. Having allowed the RMB to appreciate at a record pace earlier in the year, the rate of change in USD/RMB has slowed to a standstill, touching a zero rate of change over one month for the first time since late summer. While some of this could perhaps be attributed to a higher import bill/lower trade surplus and short covering, it seems highly likely indeed that SAFE has been buying dollars in their usual egregious volumes to slam the brakes on RMB appreciation. (Why they should want to do so is another question altogether; Macro Man would put it down to wanting to screw speculators as well as a misguided attempt to defend exports.)
Regardless of the reason, it's clear that FX reserve manager assets are continuing to rise at a nearly parabolic pace. The BRICs alone managed to add $242 billion to their reserve assets in Q1 alone. Now, what's interesting is that a lot of that can be explained by the sharp increase in the dollar value of non-dollar reserve assets; or, put another way, despite the marked increase in reserves, Macro Man calculates that Voldemort and co. had relatively little EUR/USD to buy to maintain portfolio benchmarks. Indeed, Macro Man's model put the required quarterly EUR/USD purchases at their lowest level since Q3 2004.
And yet, anecdotal evidence suggests that FX reserve managers were highly active in the FX market buying euros in the first three and a half months of the year. What's going on here? Macro Man can come up with a few possible explanations:

1) After their early April buying spree in EUR/USD, Voldy and co. found themselves overweight euros at 1.60, put on their value hats, and said "oh sh**. Sell, Mortimer sell!"

2) French Finance Minister Christine Lagarde got SAFE on the dog and bone and gave them the same "hairdryer treatment" she treated the G7 to. To avoid more of the same, they've agreed to let EUR/USD come a bit lower for a few weeks until she's found something else to complain about (ECB rates, anyone?)

3) Perhaps...just perhaps...they've realized that in walking EUR/USD higher, they have helped drive food and energy prices higher via the invoice currency effect, and that they are shooting themselves in the foot by generating social unrest (via food and energy inflation) through their FX market activities?

On second thought, maybe none of these is the case. Maybe they're just selling euros because they're ****s.
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Banker
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May 6, 2008 at 12:26 PM ×

Crude making new highs and the Euro well below 1.6000. I think (repeat think) we have seen a top for a while and that dollar will grind higher in the coming weeks/months.

Banker

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Anonymous
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May 6, 2008 at 1:07 PM ×

tis quite possible that central banks now find value in the $ relative to the euro -- or that the PBoC got a strong message from Europe/ France not to buy more -- or both.

a technical point though for mr macro. There is pretty good evidence that the total increase in China's foreign assets may be substantially larger than the reported increase in its reserves: $40b for the state banks (higher reserves), an unknown sum for the CIC. A bigger flow would have made more EUR purchases consistent with a portfolio benchmark ...

Am curious though about what the Bank of Russia and the Gulf funds/ central banks have been doing. Russian reserves are once again growing at a nice clip, which usually implies steady purchases of EUR. And well oil is at $120 and goldman is talking $150-200, which means the gulf is flush ..

bsetser

p.s. agree voldy is trying to deter speculation by holding the rmb flat, and your post raises the possibility of a broader policy shift -- one where they decide to hold the rmb constant v the $ but get real appreciation from a rising $, something that they could help bring about by scaling back their $ sales.

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Anonymous
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May 6, 2008 at 1:16 PM ×

...or maybe they just want to show Mr. Sarkozy, who still has to reserve his seat for the Olympics' opening ceremony next August and talked a lot about Tibet recently, how powerful they are, but in doing so they happened to soften euro, just like the French wanted to do...

Anyway, I don't see interest rates differentials between EUR and USD to narrow any time sooner than September or October. See today EU PPI at 5.7%, vs. 5.3% in February, or EU PMI up at 52.0, vs. 51.4. Latest data from UK seem instead worsening sooner than expected - time to short GBP?

AT

PS - I virtually owe you one pound after FIORENTINA missed the Uefa final :(

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Macro Man
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May 6, 2008 at 1:20 PM ×

The Asian "private" sector is a bit more difficult to track anecdotally from my side of the phone, Brad, but yeah, undoubtedly those guys have helped incerase China's stock (and indeed flow) of foreign assets.

From what I gather, Russia was an enthusiastic buyer of euro until relatively recently, but the newsflow in that regard seems to have dried up a bit. That having been said, I gather they continued to buy after Voldy turned seller.

As for the Middle East, they've been pretty quiet recently in the euro. What's interesting is that Gordo et al seem to have scared them out of £, where they were huge buyers over the past few years.

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James
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May 6, 2008 at 2:31 PM ×

Its too bad Brads writings about CBs becoming the dominant players in the currency markets isnt getting more attention. Its hard for me to believe the geopolitical fireworks wont start soon. Without price stability the whole world will face a massive crisis.

All these central banks seem to be influenced by different motives, making balance nearly impossible.

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Anonymous
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May 6, 2008 at 3:02 PM ×

please pardon my ignorance but can you please explain who voldemort is and how mechanistically China buys eur/usd to keep rmb appreciation at bay?

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Macro Man
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May 6, 2008 at 3:11 PM ×

Voldemort is PBOC/SAFE, and they intervene in USD/RMB in enormous size, and then usually turn around sell some of the those USD for euros in the open market, in a size that's generally big enough to push the market in their direction. Except when they sell euros, as has been the case over the past couple of weeks.

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Anonymous
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May 6, 2008 at 3:37 PM ×

Thanks, hence the USD selling is by PBOC etal is solely or mainly a function of fx reserve diversification?

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Macro Man
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May 6, 2008 at 3:41 PM ×

One man's "diversification" (actively decreasing the $ share of reserve assets) is another man's "maintaining portfolio benchmarks" (keeping a relatively steady euro share of a rapidly increasing stock of assets.)

Either way, these guys are a virtually hegemonic presence in G10 FX markets, usually as a net dollar seller- except recently, when they appear to have turned net dollar buyer.

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Anonymous
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May 6, 2008 at 3:59 PM ×

Thanks again, are there hard numbers on the PRC's stated reserve/portfolio requirements/benchmarks? Since the USD selling stopped why would they in turn start selling EUR? Not only statically stop buying it, but actually turn seller? I wonder how much the changing European economic climate has contributed to these flows...its been my idea for a while that usd recovery could persist for a while on the changing paradigm not necessarily from usd weakness to strength but usd weakness to eur weakness for example as the us recession is exported globally...such a change may warrant sustained correlative deviations too... you said the hegemonic behavior of cb's specifically the bric's was behind a lot of this and I think the whole macro key going forward is how these asset shifts occur and how sensitive they are to either acting preemtively to the growing climate of slower global growth or reacting to it as a consequence...meanwhile does a medium term usd recovery spell higher g-7 bond yields and a flatter curve?

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Macro Man
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May 6, 2008 at 4:23 PM ×

Some countries do provide hard numbers on their FX reserve allocations. Unfortunately for many of us, a lot of the big accumulators do not- though it's fortunate for Brad Setser, who's made a cottage industry out of deconstructing their behaviour.

To a degree, the impact of any USD strength on other assets probably depends on second order effects. Are commodities, including oil, higher or lower? Is economic activity data showing recession, muddle through, or recovery?

A dollar recovery spurred by robust US growth is a bear flattener....but a dollar recovery spurred by Europe and Asia joining the US in (at least quasi) recession is a bull steepener...

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May 6, 2008 at 4:43 PM ×

Or maybe your idea that central bank demand was driving up EUR/USD is wrong......it never made much sense to me anyway. As you say to anonymous@3.02, SAFE buy lots of dollars, then sell some for euros. Call me simple if you like, but that sounds to me like it should strengthen the dollar vs the euro.

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Anonymous
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May 6, 2008 at 4:56 PM ×

I would guess that Voldemort is following the Japanese adage of not becoming the tallest nail.

European politicians like Sarko have drawn various Euro/dollar lines in the sand and then, as Europeans will do when the ECB follows its mandate, stepped back from them. But everyone has been nervous over the rise of the Euro. If European growth follows American growth down, it's bad news for everyone.

The Chinese have done everything they could to prevent the RMB from rising without annoying the Americans, but have succeeded in annoying the Europeans. The next step, I would guess, is for them to annoy the Japanese.

--Charles of MercuryRising
www.phoenixwoman.wordpress.com

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Anonymous
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May 6, 2008 at 5:07 PM ×

my concern is a bear steepener...and whether that can happen and under what circumstances? Stagflation? $120+ oil prices will cripple the global economy. What kind of maneuverability do cb's have under such a scenario? Clearly recent flattening, particularly in the USD curve is indicative of the market's uncomfortability with ultra low official rates. In general such low rates are unnatural and the markets- plural- risk, equities, bonds, etc. want badly to anticipate an assimilation of policy normalization... Consider the 2yr note's correction against late 2002when under similar circumstances a similar result followed when fed funds were 1.75% before ultimately going down to 1% and 2's traded back down nearly 200bps. Similar bond market reaction was seen in Japan when the BOJ first took rates below 2%... There are few historical precedents of a central bank's lowering rates while the market is actively pricing hikes later- at least as far as the Fed's concerned. There's a risk that an ultralow rate regime can persist for a long time, but this would counter the staglflation ideas above to an extent I think...

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Macro Man
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May 6, 2008 at 6:20 PM ×

RE, China's dollar buying does indeed support the dollar...against the currency it sells (RMB) to buy dollars. I don't think anyone would argue that USD/RMB would be lower if PBOC had kept their hands in their pockets over the last few years.

Then again, PBOC's dollar selling also depresses the dollar against the stuff that PBOC chooses to buy against it...such as euros.

A swift look at a EUR/RMB chart would certainly appear to suggest that their activities may have had an impact. Your assertion that PBOC's USD buying should support the $ against the € would only be correct if the RMB and EUR were reasonably good subsitutes for each other...which, of course, they are not.

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Macro Man
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May 6, 2008 at 6:21 PM ×

Anon, the real sting in the tail of stagflation will be if/when financial assets undergo a de-rating like they did in the 1970's. That is the really ugly scenario, and one which has a nonzero chance of playing out in my view...

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May 6, 2008 at 6:50 PM ×

MacroMan,

This is how my nerdy thinking goes. Perhaps you can explain where it is faulty.

The dollars bought for renminbi (because that is the pair that PBoC/SAFE intervene in) and then sold for euros cancel out. So we are left with lots of dollar buying vs renminbi and much less euro buying vs renminbi.

A transaction in any currency pair will raise the currency bought and lower the one sold relative to all other currencies ("the background"), but the amount of movement depends on the "weight" of the currencies (ie how heavily they are traded generally), like Newton's third law. The dollar is a heavy currency, so the intervention may not lift it much relative to the background. The euro may be lighter, but not that much, and China is buying a lot less euros, so the intervention lifts it less. The effect of the intervention is therefore to lift the dollar relative to the euro.

What's wrong with that?

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Macro Man
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May 6, 2008 at 7:17 PM ×

The problem is that we don't know where the dollars that are sold against RMB "come from", or what they would be doing if they were not sold against RMB. Now, it's true that a lot of these dollars, but by no means anywhere close to all of them, come from China's trading activities.

Capital inflows, however, still represent a large portion of the other side of PBOC's activities. And I'd be willing to bet that a decent amount of that money would, if it weren't going into RMB, would remain in USD. Hell, some of those dollars wouldn't exist at all, as they are created by fake invoicing or created via derivative products by the banking system. It is the dollars that would otherwise have been dollars (or a figment of someone's imagination) that, sold for euros, has a meaningful impact on the euro/dollar exchange rate.

If I start with $50, and sell that and a further borrowed/invented $250 against RMB, SAFE takes the other side. If SAFE then sells 30% of the $ I sold for euros, they've sold more dollars than I actually had to start with.

While this is of course an exaggeration of the true scale of 'shadow dollars' that the world financial system creates, I think it is emblematic of what goes on.

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May 6, 2008 at 9:30 PM ×

Interesting! Then in addition to believing that China will be unable to sustain the peg, and therefore being willing to hold a short dollar long renminbi position, I guess the market also has to believe that the euro is too strong against the dollar, such that the residual dollars (that China does not retain) are willingly held against a short in euros.

Thanks for explaining your argument.

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D
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May 7, 2008 at 5:41 AM ×

The central banks do not set interest rates, they stabilize (manipulate) them in the short run. The FRB is making every effort to promote the discount window carry trade, but their manipulations are limited to their balance sheet...how many of you have examined their commitments in TOMO, POMO, TAF, TSLF, PDCF, Bear relative to their balance sheet? The ice on the lake is going grey...

The JPM-TGT credit receivables deal announced on Monday is the latest template to save non-financial financial companies. Good thing they have money to buyback stock! [/sarcasm]

The dollars that are being sold against RMB originated from the monetization of some asset (house?) or service (margin?). With the debt market repricing US debt higher, it is only a matter of time before we can no longer deny that slept with the ugly lady known as cascading default.

PS - The cascade started in 2006 and became undisguisable by July 2007.

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D
admin
May 7, 2008 at 6:18 AM ×

Indulge yourselves:

April 29,2008

http://www.treas.gov/press/releases/hp945.htm

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Anantha
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May 8, 2008 at 1:59 AM ×

as you wrote, it is NONE of the above. Exporters are squealing in Southern China. That is why.

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don
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May 8, 2008 at 2:48 AM ×

rebeleconomist:

It is not just the current amount of intervention, but the change from the prior period that will determine the effect on currency values in the current period. For example, if dollar purchases were $50b last period, dollar purchases of only $10b this period would result in dollar depreciation, all else equal. Similarly, a shift from $50b in dollar purchases and $20b in euro purchases last period to $50b in dollar purchases and $10b in euro purchases in this period could result in euro depreciation versus the dollar.

In fact, the euro is so far overvalued, that even with constant volume of euro-supporting intervention, the euro could easily fall, because less overvaluation would be consistent with a the same effect on trade flows as trade adjusts over time to the relative price change.

A constant volume of currency intervention to keep the yuan undervalued would produce a constant trade surplus, but would also be consistent with an appreciating yuan, even if there were no response on the part of any other capital flows.

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Anonymous
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May 21, 2008 at 8:58 PM ×

Like I said on your Seeking Alpha version of this post: "behavioral" and "through $1.60 with a bullet".

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