ECB dilemma: Whatever it can…

As you know, the Fed eventually stepped out of the market with its last POMO of QE4Ever yesterday (the NY Fed revealed that it monetized $931mio of bonds maturing between 2036 and 2044); normalcy returns today for the US. However, the game is starting in Europe with the ECB that started its covered-bonds purchases last week (a mere 1.7bn EUR according to Bloomberg). And there is more coming: ABS purchases, second round of T-LTRO on December 11th, corporate bonds in the secondary market and eventually sovereign bonds if needed.

Remember the ECB’s most important chart (see below) right now, the 5Y5Y forward swap rate, aka the preferred measure of medium-term inflation expectations. As a reminder, a 5year/5year forward swap represents a swap beginning in 5 year with a maturity of 5 years whereby counterparty pays fixed while the other pays a floating rate (3M EURIBOR for instance) on the nominal amount (for more details, see article Introducing the Swaptions (and IRS)).

As you can see it, the key number is 2 percent (or 200 bps). The rate moved below the threshold since the end of the summer and is now fluctuating around 1.80%.


(Source: Bloomberg)

It is the third time the ECB is intervening directly on the secondary market to ‘fight against’ deflation threat. As a reminder, annual inflation came in at 0.3% in September, far below the central bank’s 2-percent target (none of the countries below has an inflation rate as high as 2 percent). Moreover, officials reduced their inflation and growth forecasts to 0.6% and 0.9% respectively (from 0.7% and 1% respectively) for 2014 at the September’s meeting.


(Source: Eurostat)

After the 1tr EUR+ balance sheet expansion announcement (Draghi targets dimensions the central bank used to have in the beginning of 2012), there has been some talks that the ECB may struggle to find enough corporate bonds and ABS to buy (eligible as collateral). While EZ policymakers stated that there is approximately €600bn of eligible covered bonds, the market estimates that the ECB will only able to buy a small portion (a fifth?) of those assets. As banks benefit from covered bonds’ low risk weighs under Basel 3 rules, there is little chance they will sell it to the ECB and use the money to lend to non-financial institutions. Back in 2012, in its Covered Bond Program Round 2, the ECB struggled to meet its 40bn-Euro target and purchased only €16.4bn of those assets (see chart below from ZeroHedge). We will see how it will go this time.


(Source: ZeroHedge)

Any solution there?

We know Germans are not very keen on public QE (sovereign bonds), we call it the Draghi-Weidmann fight. Weidmann describes government bond purchases as a ‘dangerous path’, in addition to be forbidden (Article 123 on the Treaty of the Functioning of the European Union, the prohibition of monetary financing). Therefore, investors will closely watch the updates on the ABS and other corporate bonds purchases package, to see if the ECB can meet its goal.

After the ECB announced that 25 banks failed its third stress test (see details in Appendix 1), and that the cumulative capital shortfall among the 25 failures was €25bn (less than the €27bn reported in 2011), the ‘real’ scary figure was the €135.9bn increase in Eurozone bad debt to an outstanding amount of €879bn, which represents roughly 9% of EZ GDP (see details in Appendix 2, Bad debt is called NPE – Non-Performing Exposure). As ZeroHedge mentioned it in its last articles on the AQR/Stress test results, maybe the NPE should be the ECB ‘hot spot’. How long until Draghi monetizes those assets?

Appendix 1:


(Source: ECB’s website)

Appendix 2:


 (Source: ECB’s website)

Watch the correlations…

As EURCHF is barely moving, trading within a 60-pip range (1.2120 – 1.2180) over the past month and a half, EURUSD and USDCHF continues to trade almost ‘perfectly inversely’. Over the past the 18 months, the correlation between the two pairs stands at -97%. The ECB’s May conference followed by the introduction of a package of ‘easing’ measures from ECB policymakers have triggered a Dollar Strength environment. As you can see it on the chart below, EURUSD (black bar) is down 6.5 figures while USDCHF (orange bar) is now trading almost 4 figures higher at 0.9075.

In addition, the 6 consecutive NFP prints above the 200K level and a better-than-expected GDP print (Q2 GDP first estimate came in at 4.0%) played in favour of the US Dollar over the past few months. Yellen sounded quite hawkish at her last testimony in front of the Congress, and it seems that US policymakers have regained some confidence concerning their ST monetary policy (according to the July FOMC meeting).

However, it didn’t take too long to see weak figures again. Yesterday, Mortgage applications fell 2.7% in the week ended August 8. The smoothed 4-week moving average is now back to September 2000 levels despite lower Mortgage rates (30-year Mortgage Rate is now stands at 4.35%, down from 4.7% in January). Moreover, we saw slightly later that retail sales missed expectations for the third month in a row with an unchanged flat print in July (vs. expectations of a 0.2% rise and down from the 1.5% growth rate seen in March). With retail sales accounting for one third of consumer spending in the US, the IMF cut once again (end of July) its 2014 growth forecast from 2.0% to 1.7% after the National Retail Federation cut its 2014 retail sales growth outlook from 4.1% to 3.6% (Winter blamed).

If we have a look at the chart below, we can see that the US Dollar has been stable since the beginning of August. We are pretty much bearish on the Euro based on poor fundamentals (Q2 GDP first estimates disappoints again and came in at 0.0%) and aggressive ECB easing; our EURUSD medium term target (H2 2014) stands at 1.3000, which corresponds to July 2013 levels. Investors could potentially fly to the Swissie in the middle of this high-pressure geopolitical environment. We think that EURCHF is on its ‘slow’ way to test the 1.2000 SNB once again. Therefore, with a EURUSD target at 1.3000 and EURCHF at 1.2000, it gives us a USDCHF MT target at 0.9200.


(Source: Reuters)