Friday, March 04, 2011

Euro Wars V : The ECB Strikes Back

Well yesterday went as badly as it possibly could for TMM, with just about the only thing right with yesterday's post being the title, as Mr T and the A-Team reminded them precisely why they try to avoid trading Euribor at all costs. The Baron Von Trichet was almost as hawkish as he could possibly have been, sending rates markets into a tailspin as memories of June 2008 flashed before the eyes of many a rates trader. But pain aside, what are the implications?

Ladies and Gentlemen, may we introduce the new (old) star of the G7 currency show: the Euromark. Ultimately, while currencies are driven by a multitude of factors, from Current Accounts to rate spreads to geopolitical events, over the long term, divergences from the Real Exchange Rate are largely explained by Real Interest Rate spreads, something TMM highlighted in their 2011 Non-Predictions with respect to their strongly held view that USDJPY is going nowhere fast despite the best efforts of punters to try and rally the USD (thus far, unsuccessfully). And it is in that respect that HMS TMM are viewing the U-ECB torpedo that sank them yesterday after heavy gun fire throughout the week from other quarters. While TMM and many market participants view an early hiking cycle from the A-Team as something of a policy mistake (more on this below) in terms of the Eurozone as a whole, it also demonstrates that unlike many central banks around the world (for example, the Fed, the Bank of England and most of the EM world) that their only two priorities are monetary stability and preserving the value of the currency in terms of inflation. While some have argued that this is more about trying to impress the Germans after Darth Weber's exit, stage left, it seems to us that Club Med are being sacrificed on the altar of the Bundeathstar. That is very bad for the periphery, however, it is very good for a Euro that is increasingly looking like The Deutschemark under ERM as higher rates are entirely appropriate for the German powerhouse.

The below chart shows the EUR (orange line), the nominal 2yr swap spread (green line) and the 2yr real rate spread (white line). While obviously not a perfect fit (certainly amongst the noise in late 2008), from 2004 until early 2010, in broad terms, the real rate spread did a much better job of explaining the Euro's valuation than the nominal spread did, and from July 2010 onwards, similarly so. TMM were originally going to throw the statistical toolkit at the below in order to strip out the credit-induced risk premia applied to the Euro in the first half of 2010, but after a heavy night's drinking this suddenly seemed like too much of a task given that the pounding of their portfolios has extended to their heads. So that will have to wait for another day. but if we accept the view that about 10% risk premia was added into the currency back then, it's not too much of a stretch of the imagination to imagine that the risk premia-adjusted EUR would have a 1.50-handle on it. But it would still be "undervalued" relative to the real rate spread. Given that the ECB is forcing real rates higher in Europe at a time that the Fed is unlikely to budge for at least another year or more, as headline inflation prints drift higher with Oil, TMM find it very difficult not to own the EUR when the real rate spread is pushing its highest since mid-2008 and prior to that, the mid-1990s. And it's not just the spread that is important in this respect, in the US, the absolute value is -1.39%, while the European equivalent is +0.21% - small, but positive, nonetheless.

For completeness, TMM's EURUSD model that includes the VIX & Spanish CDS is also pointing north:

So that's the Euromark, what about those Club Med countries pegged to it?

As TMM noted earlier this week, an increase in the ECB's Refinancing Rate is not materially different for the PIGS than a rise in their bond yields, and in keeping the yield curve steep, the ECB have in some respects been helping banks rebuild their capital. But clearly they have decided "enough is enough" and put the bank capitalisation problem squarely in the court of the fiscal authorities. Under the prism of this policy, the ECB is forcing the politicians that have, erstwhile, been dragging their feet with respect to recapitalising their banking systems properly and tightening the Stability & Growth Pact to act such that the Euro is no longer "soft" in terms of monetarism, and also in terms of fiscal prudence. Should politicians still reject further moves towards a North European fiscal policy, it is likely that Ireland, Greece & Portugal restructure, but given Spain's fiscal sustainability, this is not particularly bad for the Euro whether these countries stay or leave. In fact, it looks a lot to TMM like the Deutschemark under ERM. In terms of growth impact, obviously rates moving higher is a firm negative for those countries undergoing internal devaluation and can only mean an underperformance of their equity markets. And while TMM think that the easy money in the long DAX/short IBEX trades has been made and that - ultimately - as per their 2011 Non-Predictions, that the IBEX will outperform this year, in the short-term, at least, TMM believe markets will focus on the additional pain that the periphery will be forced to bear.

TMM were going to write a completely different post today answering the question "Is this February 1994?", but decided that that will have to wait until next week given their pounding heads. But the crux of the issue is whether or not yesterday's surprise pre-announcement of a rate hike will push the focus towards bringing forward expectations about a G7 rate hiking cycle. TMM are undecided on this, except for their view of the Fed on hold for a long time, but that does not necessarily mean that markets cannot price in such an event. And thus, in the short-term at least, the bias towards a more protracted front-end sell-off seems likely. As has been argued elsewhere, the Nikkei tends to outperform in rising yield environments so TMM pick this particular graveyard as their long, against which to sell Eurostoxx.

And with that, TMM wish all their readers the very best of luck with this afternoon's lottery.


Tradebot said...

Humm thinks yesterday's noises from Tricky Trichet could be more of a political sop to Mrs Merkel and Bundesgang, kinda of "let's all play hawks so Germans can trust to so we can get our man Draghi to take over in October". So all it took was Trichet to bring rate hikes up the curve by a quarter - only surprise was the rates market reaction who must have been long and wrong to the ECB press conf.

How high it will go? Up to 2% before Oct? Will it really matter as per European growth? Probably not as structural issues weigh on PIGS more than short end refi rate.

Tradebot said...

Well, given the Euromarkets tendency to call things wrong , what are the odds that Portugal tapping the ESF have not been priced in. Lot of ppls in outside Europe think the sovereign issue is "so 2010" so out of sight out of mind... but they are mistaken as nothing has been solved , only the day of reckoning has been delayed.

However at these levels it is hard to have any conviction trades on this view.

Right Field said...

The way EUR trades and fact Trichet came out the way that he did says two things: either a PIIGS deal or ESFS expansion already done behind scenes or this was a shot across the bow to get this done immediately..... otherwise the dissapointment factor at the upcoming summit could be large...

Anonymous said...

It's been a while since a major CB introduced the element of surprise. The effects of a strong Euro are probably more of an issue than anything else.

Wouldn't put it past the ECB to further bailout peripheral bond markets whilst simultaneously hiking.

Leftback said...

FT on Portugal earlier this week. The analysis leaves no doubt that sovereign issue is going to be "en vogue" in 2011... also an interesting comparison with Spain, a domino that may not topple until much later.

Portugal's Broken Debt Market

Leftback said...

Off-topic, the buying of 2y USTs this morning, which were briefly at 80bps, now at 68 bps, was one of the more bizarre things we've seen recently. Anyone got a decent explanation?

Anonymous said...

Yes, I was doing a cheeky rebalance of 2% of my personal portfolio out of Gold and into 2yr T - whoops, sorry!

Nic said...

There is the 1.40 EURUSD that you guys called for way back when. Well played TMM

Nic said...

Anonymous said...

Thanks for the insight. One one the many reasons why tmm is still going strong.

My view. Will a 25 bps hike from 1% really matter. The fed has messed us all up. Rates are still so historically low. If 3% rates are too high what does that really say about the world.

MacroAnt said...

Great Post Guys,

I've read the Fed's QE approximates to around 75bps of cuts, any idea what the ECB's liquidity measures does?

Can these measures co-exist with a rate hike? In some "mutant monetary policy" or will they effectively suppress the effects of the hike?

From AEP's Latest:

• Spain is now being whacked again. One-year Euribor rates jumped 14 basis points to 1.92pc within hours after ECB chief Jean-Claude Trichet uttered the code words “strong vigilance”. As the ECB knows, this is the rate used to price most Spanish mortgages.

Spain has over 90% floating mortgages(, these liquidation measures wont be able to offset that domino effect?

Anonymous said...

MacroAnt, with the ECB it's relatively easy, as one can just look at the EONIA/refi spread for a very rough and simplistic approximation of how effective ECB liquidity policies are. I'd say it amounts to smth like 70bps. Obviously, there are all sorts of issues to a rough and ready estimate like this, but it should do.