The Euro Strength and the ECB’s options

The point of today’s article is to debate a little bit about the ECB meeting next week (March 6th) and what are policymakers’ options to counter a strong ‘Euro’ combined with low inflation.

1. The ‘Euro Strength Story’

However, let’s first review the few factors that have contributed, in our opinion, to the Euro strength over the past year. The first indicator we usually watch is the peripheral-core spreads, which determines the Euro zone risk and investors’ sentiment about the global outlook of the Euro area. To give you an idea, the Italian and Spanish 10-year yields are now trading at their multi-year lows (2006 levels) at 3.47% and 3.49%. Since the famous ‘Whatever it takes’ phrase pronounced by Mr. Draghi in July 2012 (27th) followed by the introduction of the OMT program one week later, the single currency has constantly been pushing up against the greenback as policymakers’ support brought back investors’ interests in the Euro zone. Below, there is a popular graph that we like to watch overlaid with EURUSD spot rate, the 3-year Spain-German yield spread. As you can see it, the narrower the spread (white line, inv. scale), the stronger the Euro (purple line)…

(Source: Bloomberg)

The second indicator that played in favour of the Euro strength was the divergence between the ECB and Fed’s Balance Sheet Total Assets. After the Fed announced its QE-4-Ever ($85bn monthly purchases) in the last quarter of the year 2012, the central bank’s balance sheet has constantly been surging since then, increasing the money supply and therefore impacting the value of the US Dollar. As you can see it on the table below, the Fed’s B/S expanded from $2.91tr in December 2012 to $4.15tr reported in mid-February this year, which represents a 42.6% increase. At the same time, the ECB, unlike the other major central banks, has largely refrained from using its money-creation powers and its assets holdings were reduced from €3.02bn to €2.19bn (-27.5%).

Source: Bloomberg; ECB (ECCSTOTA Index) and FED (FARBAST Index)

Therefore, below is another chart that we like to watch overlaid with EURUSD, the Fed-to-ECB Balance sheet ratio. As you can see it, the ratio (yellow line, inversed scale) is up from 0.9000 to 1.3783 over the past year, while EURUSD is up 8 figures down from 1.3000.

(Source: Bloomberg)

The last point that played a role in the ‘Euro strength story’ would be the big quarterly increases in the surplus of the EZ payments current account. Current account, which spots the difference between a nation’s savings and its investments, is an important indicator about an economy’s health. According to Eurostat, Euro Zone current account showed a surplus of 221.3bn Euros over the 12 months to December 2013, compared to a surplus of 128.6bn Euros a year earlier (surplus means basically that the Euro is a net creditor to the rest of the of the World).

After its low of 1.2040 reached on July 27th 2012, EURUSD is now trading around the 1.3800 level, which seems to be ‘uncomfortably too high’ for policymakers. Therefore, Draghi has now two issues, which are a low inflation rate combined with a ‘strong’ Euro. We saw last week that final annual EZ inflation edged up 0.1% to 0.8% in January, but still remains well below the ECB 2-percent target. Private loans have been contracting for twenty consecutive months (-2.2% in annual terms in January) and Money supply growth (M3) in the Euro still sits at low levels compared to the ECB’s 4.5% reference rate (+1.3% YoY in January).

In addition, the decline of the German CPI (Flash Feb eased to its lowest level in 3-1/2 years at 1.0% YoY in February, down from 1.2% YoY the previous month) is adding pressure to other countries of the Euro area, as they need to have a lower inflation than Germany in order to regain competitiveness.

2. The ECB’s options…

The market is talking about further easing, however it seems to me that Mr. Draghi is running out of options. Quantitative easing is out of the question as the Germans won’t approve it for the moment. Then, we believe that another LTRO (3rd one) wouldn’t be successful as banks are still stuck with the LTRO1 and 2 reimbursements. In addition, it may have a negative impact on the single currency in the short term (250 pips ‘correction’ two weeks following the first two announcements, however liquidity will continue to keep sovereign yields at multi-year low levels and therefore support the Euro). Eventually, there are market talks of negative deposit rate, but it seems to me like the ‘tool of the last resort’ and we believe the situation is not that critical yet. When we asked the question to Thomas Stolper (Chief FX Strategist at Goldman Sachs), he added that negative deposit rate is a dangerous tool: ‘there is a risk that banks actually pass negative carry on excess liquidity on to their clients, which is risky in the periphery where this could be counter-productive’.

The only option next Thursday remains a tight cut in the refi rate (probably 10 bps), which we believe is strongly priced in. Therefore, the lack of reaction from ECB policymakers could continue to push EURUSD to higher levels (1.4000 at first, Sep-2011 levels), and will also benefit (as we saw yesterday) from global equity flows (as they continue to favour inflows into Europe).

Euro Zone update

Earlier today, the ECB announced money supply (Broad Money aggregate M3) in the Euro area grew as expected at an annual 1.2% pace in January and has constantly been decreasing since the high of 3.9% reached in October 2012. In addition, loans to the private sector continued to contract last month (-2.2% vs expectations of -2.1%), going against Draghi’s December expectations at the press conference.

EURUSD broke a minor support area and is now trading below the 1.3700 mark at 1.3660, as uncertainty on the developments in Ukraine trigerred a correction in European equities. The Euro Stoxx 50 index is down 1.30% since yesterday’s high; the DAX is trading slightly above its 9,500 and down 200 points from yesterday’s high despite better-than-expected employment data (number of people out of work decreased by 14K vs 10K expected).

The graph below shows us the correlation between EURUSD (in red) and Euro Stoxx 50 (in green).

(Source: Reuters)

This evening, we will publish an article where we will talk about ECB ‘easing options’ ahead of next week’s meeting (March 6th).

FOMC Minutes Review

Yesterday, traders were waiting for the January FOMC minutes after policymakers announced then that the Fed will continue the course reducing the asset-purchase program by another $10bn down to $65bn a month. We saw that several participants were in favour of continuing to reduce the pace of purchases at every meeting, which means that QE4Ever would come to an end in December 2014.

Despite two poor Non-Farm-Payrolls prints (revised 75K in December, and 113K in January vs 180K expected) and a slowing housing market (Housing starts were down 16.0% in January to 0.880M vs 0.950M expected, Mortgage Applications dropped to a 19-year low with the index falling by 16% over the past 5 weeks), US policymakers didn’t seem concern about the fragile recovery the economy seems to be facing at the moment. This decision could act in favour of the US Dollar (against most of the currencies) as the market was expecting a dovish Yellen before she took office as Chairman of the Federal Reserve; instead, she has been defending the gradual tapering path Ben Bernanke outlined in December.

Another important announcement the market was waiting yesterday was the update on the forward guidance. As you know, following the December 2012 meeting, Bernanke and his fellows introduced the forward guidance and indicated that the Fed Funds rate will remain low (0 – ¼ percent range) as long as the unemployment rate remains above 6.5% (with an annual inflation rate below 2.5 percent). With the unemployment rate falling from 7.9% to 6.6% in the past 14 months, it stands now closed to the 6.5-percent threshold and traders are now wondering if the Fed will act earlier than expected. Policymakers announced already a few times that there was no immediate need of such an act and that they would wait the jobless rate to decrease well below that threshold before starting to tighten. One of the market’s expectations now is that the Fed may decrease the threshold down to 6 percent in one of its following meetings (March meeting seemed likely until yesterday). However, yesterday’s minutes brought some confusion with participants favouring ‘qualitative guidance’ now, as several members suggested that ‘risks to financial stability should appear more explicitly in the list of factors that would guide decisions about the Federal funds rate’.

The US Dollar index eased by 20 pips after the FOMC minutes, and eventually found support slightly above 80. It is now trading at 80.28, and we believe there is potentially further room for Dollar strength in the short term. The next resistance zone on the topside stands at 80.70 / 80.80.

(Source: Reuters)

Time to go Long GBPAUD

For the past couple of weeks, GBPAUD has been recovering from its January losses as traders and investors are starting to price in a BoE rate hike in early 2015 (some observers target Q4 2014). Firstly, the UK unemployment rate fell sharply over the past few months since Carney introduced the forward guidance back in August 2013 and now stands at 7.2% (edged up 0.1% today in the quarter to December, but claimant count change down 27,600 In January vs. expectations of 20K), closed to the 7-percent threshold for considering a rate rise. Secondly, fundamentals remain pretty strong in the UK, with PMIs well above the 50-recession level (Mfg PMI printed at 56.7 in January) and the BoE raising its growth forecast (again) for 2014 from 2.8% to 3.4%.

Therefore, even if the annual inflation rate undershot the Bank of England’s 2-percent target for the first since 2009 (1.9% YoY in January), boosting the central bank’s case that there is no immediate need to raise the Official Bank rate, the British pound should continue to be supported against most of the currencies as the market is starting to believe in an early ‘BoE tightening’ scenario.

On the Aussie side, the $A dollar has recovered quite a bit since its low reached in late January (0.8660 on January 24 against the USD) supported by the demand for carry trades (AUDJPY is trading at 92.20, up four figures in two weeks) and driving other RISK-ON assets such as equities (S&P500 back to its December highs at 1,838). However, higher levels on the Aussie brought back traders’ interest to short the currency again as they consider that the recovery won’t last for long. Fundamentals remain weak in Australia as we saw last week with official employment data that showed a 3,700 fall in January versus a 15,000 rise expected by economists (Unemployment rate stands now at a 10-year high at 6.0%). Moreover, the Australian Bureau of Statistics reported overnight that the wage price index slowed to 2.6% YoY in Q4 last year (slowest annual increase since the series began in 1979), confirming RBA Governor Glenn Stevens’s commentary ‘the Aussie is uncomfortably high’.

Therefore, we maintain a bullish view on GBPAUD in the medium term; 1.8400 seems to be a good support to start buying on dips for a test back towards 1.8650 at first (1.8800 is our MT target).

(Source: Reuters)

CBOE Skew vs. VIX

Today, we would like to speak about the convergence and divergence between the SKEW and the VIX. We guess that everybody is familiar with the VIX that reflects a market estimate of future volatility (introduced in 1993 by the Chicago Board Options Exchange – CBOE, measures the 30-day volatility implied by the ATM S&P500 option), however let me introduce you to the CBOE SKEW index.

Since the crash of October 1987 (Black Monday, DJ down 22.6%), investors have realized that S&P500 tail risk (returns that are under 2 or more standard deviations below the mean) is significantly greater than under a lognormal distribution. Therefore, the ‘skew’ measures the perceived tail risk of the market via the pricing of OTM options. A rise in skew indicates that ‘crash protection’ is in demand among institutional investors (also called the ‘big players’ in the SPX options market).
A ‘low VIX/high skew’ combination says that the market is complacent, however the ‘big players’ perceive far more tail risk than usually. Therefore, a surprise increase in realized volatility may not be too far away.

If we have a look at the chart below (which represents in fact the VIX and the SKEW), we can see that VIX (green) is sitting at very low levels at the moment (13.57%) and may need to release some ‘energy’. In blue, we have the Skew index which has been fluctuating within the 125 – 130 range for the past few weeks (now trading at 129.25). We recommend you closely watch your positions when the index is approaching the high of the ‘historical’ 100 – 150 range.

(Source: Bloomberg)

If you extend the historical chart since 1990, you can see that the perception of increased tail risk can be early (skew was above 130 level in 2005 already while the VIX was trading at 10.0 at that time), but it definitely remains one the ‘fear’ indicators watched by Wall Street players (with CSFB – Credit Suisse Fear Barometer – index).

The Japanese Yen and its drivers

Global economic tensions brought back interest for the Japanese Yen (Risk-off environment), which was the only currency to perform against the greenback in January; and as some investors said: ‘the JPY carry trade is the only thing that matters’. According to the CFTC, traders have reduced their net short positions to -86.2 (000’s of contracts) in the week ending Jan 28 (from -115K in the previous Commitment of Traders report last week). The Gross yen position have been constantly reduced since Mid-December and we are now with 102.2K short contracts (vs. Long 16K long), closed to three-month lows.
USDJPY is down 340 pips since its high of 105.40 reached on January 2 this year and is now testing the 102.00 resistance again. The question is now: is there more room on the downside for this month of February?

In this article, we display a few charts that we like to watch before starting considering taking a position in USDJPY.

The first one is USDJPY (in black) versus the 10-year Treasury yield (in green).
Since policymakers pronounced the ‘QE Taper’ words last summer, LT yields have started to increase in the US bringing back interest for the US Dollar. Between November 1st 2013 and January 2nd 2013, the 10-year yield has surged from 2.6% to a high of 3.03%, pushing USDJPY up by 7 figures (from 98.40 to a high of 105.40). However, as you can see it on the chart below (30-min period), Risk-Off sentiment have ‘forced’ traders and investors to hold back the so-called ‘safe-haven’ assets such as US Treasuries and the Japanese Yen as fear has hit the market again in the middle of this global economic meltdown. The US 10-year yield was trading at 2.65% on Friday’s trading session, which means that we are now back at levels we saw in November last year.

The second chart that we like to watch is the correlation between USDJPY (in black) and the US equity market (in purple). In theory, when bond prices increase (i.e. yields fall), the stock market decreases and we start to see carry traders unwinding their positions. This chart shows how the US equity market (S&P 500 index) has reacted since it reached its historical high of 1,848 on December 31. As you can see it, the S&P 500 closed at 1,782.60 on Friday, down 3.57% since its December’s high (while USDJPY was down 3.22%). The 22-day correlation between the two underlying assets is now at 90%…

Another chart to look at would be USDJPY versus the Nikkei index. In the early London trading session, we usually have a quick look at the Asian fundamentals that came out overnight and watch how the equity market reacted then. It gives me an idea if it is worth considering holding a position in USDJPY in my book or not. When we see an agitated overnight session, it takes us a bit longer to decide entering either a short or long position.

Quick Technical Analysis on USDJPY:
The next support on the currency pair stands at 101.60 (December 5 lows). If USDJPY still continues to slide this week, the next level to watch on the downside will be 101.06 (its 100-day moving average), which we think the pair will hit before the NFP release next Friday.