Euro – Rothko Research Ltd.

EURCHF is the FX ‘value’ trade according to PPP

November 16, 2020 RothkoResearchLeave a comment

Unlike bonds or equities, currencies do not carry any fundamental value and have historically been known as the most difficult market to predict. In our FX fair value model page, we look at different ways of estimating a ‘fair’ value for a bilateral exchange rate. One of the simplest models is based on the Purchasing Power Parity theory, which stipulates that in the long run, two currencies are in equilibrium when a basket of goods is priced the same in both countries, taking the account the exchange rates. We know that the OECD publishes the yearly ‘fair’ exchange rate based on the PPP theory or each economy.

Based on the OECD calculations, it appears that the Euro is the most undervalued currency among the G10 world relative to the US Dollar, as PPP prices in a fair rate of 1.42 (implying that EURUSD is 18% undervalued). On the other hand, the Swiss Franc is the most undervalued currency (+26%). Therefore, if we were to believe that exchange rates converge back to their ‘fundamental’ value in the long run, being long EURCHF is the position with the most interesting risk premia among the DM FX world.

Great Chart: US Dollar – DXY vs. broader index (NEER)

July 26, 2020 RothkoResearchLeave a comment

The past few months have been marked by a significant depreciation of the US Dollar relative to major currencies. The massive liquidity injections from the Fed to desperately avoid the country from falling into a deflationary depression combined with the risk of a second ‘strict’ lockdown in some southern states (Sun Belt) have left the greenback vulnerable, with some investors speculating that the ‘Bear Market of the USD’ has eventually begun. The USD index is now down 1.7% year-to-date, following two years of positive momentum, and currently trades at its lowest level since September 2018. The US Dollar has significantly weaken against the major currencies and particularly the Euro as EU leaders have recently shown improving signs of coordination and the ‘better management’ in the Covid19 crisis will surely be reflected in the real growth differential between the two economies, which is one of the key drivers of currencies over the long run.

However, as the USD index is heavily weighted on the Euro (57.6%), it may show a misleading picture of the current state of the US Dollar. If we look at a broader measure of the US Dollar – Nominal Effective Exchange Rate (NEER), which measures performance of the USD against a broader rage of currencies weighted according to the value of trade with the domestic country – we can notice that USD NEER is up 3.1% YtD and still trades higher than its early March level. The chart below shows the interesting ‘divergence’ we observe since the start of the crisis. At this stage, the USD NEER index has given up most of its March gains, but is clearly not showing any signs of massive weakness coming ahead. Hence, we will need to see more downside on the USD NEER to confirm that a LT bear market on the USD has eventually started.

US Dollar: DXY vs. NEER (Source: Eikon Reuters)

EURUSD drivers and medium-term outlook

October 7, 2018October 7, 2018 RothkoResearchLeave a comment

1. EURUSD long-term drivers

With US interest rates testing their multi-year highs on the long-end of the curve (i.e. 10Y trading at 3.22%), some market participants have argued that the US Dollar should strengthen against all other currencies. Exchange rates have had many fundamental drivers through history, however FX strategists have struggled to come up with a FX Fair Value model that has consistently performed well during a long period of time. For instance, a popular driver widely used in the market is the interest rate (IR) differential. Figure 1 (left frame) shows that the EURUSD exchange rate tends to co-move strongly with the 10-year German-US IR differential over time, and therefore some analysts have concluded that the rise in the 10Y US yield should benefit to the US Dollar and that the current IR differential is pricing in a much lower exchange rate (around parity).

However, we know from empirical studies that currencies’ drivers vary all the time depending on the macroeconomic situation, hence the divergence between the two times series can widen for a significant amount of time before closing out. Another interesting long-driver of the EURUSD exchange rate is the natural rate of interest differential (Holston, Laubach and Williams (2016)) estimated by a version of the Laubach-Williams model (2003). The natural or ‘equilibrium’ real interest rate, firstly introduced by Knut Wicksell in 1898 and sometimes referred as r*, provides a benchmark for measuring the stance of monetary policy in most of the economies. Figure 1 (right frame) plots the long-term relationship between the r* differential between the Euro area and the US and the EURUSD exchange rate since 1975 (using a proxy of the EURUSD prior 1999). We can notice that after a long decline from 50bps in 2011 to -100bps in early 2015, the r* differential has been rising over the past couple of years as the natural real interest rate in the Euro area moved from -45bps in the middle of 2014 to roughly 10bps in Q1 2018. Hence, if we use that proxy as a LT driver of the exchange rate, EURUSD should continue to rise as the r* differential increases.

Figure 1

Source Eikon Reuters, Holston et al. (2016)

Another important LT driver that some practitioners like to use is the current account differential. We saw previously that significant successive ‘twin’ deficits (current account and budget deficits) tend to weight on the country’s currency in the long run. For instance, as we expect the twin deficit to widen in the US on the back of a large fiscal stimulus (1tr USD deficits for the fiscal year 2019 and 2020 according to the CBO), the US Dollar should underperform against other strong currencies (i.e. Euro). In Figure 2 (left frame), we can notice some co-movements between the USD index and the US twin deficits since the early 1970s.

In the Euro area, the relationship is less visible when we plot the two times series starting 1997, however the exchange rate and the current account differential (EU-US) tend to not deviate too far away from each other in the long run. Over the past few years, the current account differential has constantly been increasing in favour of the Euro area (up from 4% in early 2013 to over 5.5% in the middle of 2018) while the EURUSD exchange rate has been depreciating on the back of a monetary policy divergence. As a reminder, the Fed stepped out of the bond market in the end of October 2014 while the ECB started its QE bazooka in March 2015. Now that the ECB is ‘exiting’ the market at the end of the year, we will see if fundamentals such as the current account will start to matter once again.

Figure 2

Source: Eikon Reuters, CBO

A popular model to ‘value’ exchange rates in the medium is the Behavioural Equilibrium Exchange Model (BEER), which estimates the FX fair value according to a set of macroeconomic and price data. For instance, one of our BEER models uses the interest rate (10Y), the inflation rate and the terms-of-trade differentials to value currencies. Figure 3 (left frame) shows the fluctuations of the EURUSD spot rate with its BEER value since 1991. The nominal exchange rate is much more volatile than its macroeconomic neutral rate, however we can notice that spot rates mean revert if they diverge too far from their equilibrium values (statistically significant when testing for mean reverting process using an ECM model). Currently, our BEER model is pricing a fair value at around 1.13, which is slightly lower than the current level of EURUSD (1.15). However, results can change drastically depending on the variable we use for the analysis. As we included the interest rate differential, we knew originally that we were not going to get a very elevated EURUSD fair value as IR differentials have been trending down over the past few years (as shown in Figure 1, left frame).

Another important chart that we like to look at is the Fed-to-ECB balance sheet total assets ratio. When a central bank is intervening in the market through its open market operations, the dynamics of its balance sheet changes and may impact the currency. For instance, between September 2012 and May 2014, the balance sheet of the ECB was contracting on the back of the early LTROs reimbursements by banks, while the Fed was running QE3 purchasing USD 85bn of Treasuries and MBS through the entire year 2013. As a result, the Fed-ECB ratio increased from 0.72 to 1.5 during that period, which played in favour of the single currency (EURUSD went up from 1.20 in August 2012 to 1.40 in May 2014). After reaching a high of 1.86 in March 2015, the ratio inverted as the ECB started its QE program that month. The Euro started to depreciate after the May 2014 meeting as market participants were already anticipating that move after Draghi’s ‘ready to act’. In short, monetary policy divergence should be automatically reflected in the exchange rate.

Figure 3

Source: Eikon Reuters, Rothko Research

2. Euro outlook

Since the beginning of the year, two important drivers of the EURUSD exchange rate have been the US Dollar strength that kicked off in mid-April, shorty followed by a sudden rise in political uncertainty in Italy. As we can see in figure 4 (left frame), the 10Y yield in Italian bonds suddenly jumped following the March elections, soaring from 1.7% to over 3%, and has been weighing on the Euro since the beginning of the summer. We usually see the Peripheral-Core yield spreads as a fundamental short-term driver of EURUSD. As long as the political instability persists in Italy, LT yields will remain elevated, depriving the Euro from appreciating.

For short term traders, it is also interesting to watch the behaviour of the EURUSD vis-à-vis the VIX index. If we plot a 30-min chart (see appendix 1), we can notice that the two times series have co-moved significantly since June. EURUSD tends to act as a risk-on asset, which means that the Euro appreciates (resp. depreciates) when the implied volatility is decreasing (spiking). There were some periods when the Euro was positively correlated to the VIX, which means that the single currency was behaving like a safe-haven asset (see what the EURUSD did during the August 2015 sell-off in Appendix 2).

Overall, there are a lot of challenges in the short-term for the Euro – elevated political uncertainty in Italy, slowing fundamentals, negative reactions to a sudden risk-off environment – however the single currency remains significantly undervalued looking at a variety of ‘fair’ value metrics. For instance, the Purchasing Power Parity (PPP) index is pricing an exchange rate at 1.33 according to the yearly Eurostat-OECD calculations. We could see EURUSD hitting new lows in the short run (1.11 is the next support in case of a sudden sell-off), however we think that the Euro has more upside potential in the medium / long term against the US Dollar, and especially if the situation improves in Italy.

Figure 4

Source: Eikon Reuters, OECD

Appendix. EURUSD (yellow line, rhs) vs. VIX (inv, lhs)

Source: Eikon Reuters

The History of the Euro (and the Euro Zone)

November 9, 2016February 13, 2018 RothkoResearch1 Comment

In today’s article, we think it could be good to recap the History of the Euro and the previous engagements European countries had before switching to a single currency regime. This post is split in two parts, the first one focuses on the most important events and treaties that led to the adoption of the single currency. In the second part, we explain the trends and reversals of the single currency vis-à-vis the US Dollar in addition to stating what we believe were the main drivers of the currency pair.

The Euro is part of the G3 currencies (with the Yen and the US Dollar) and is the second most ‘traded’ currency with a daily average of 1,591 Billion Dollars according to BIS report on FX volumes in April 2016. If the Foreign Exchange market’s daily volume equals roughly 5 trillion USD, then the Euro’s percentage share of average daily turnover stands at 31% approximately, far below the USD Dollar and its 89%. Note that two currencies are involved in each transaction, therefore the sum of all the percentage share of individual currencies totals 200 percent.

I. The political face of the Euro

Even though the Euro came into existence on January 1^st 1999, currencies of countries in the European Union (under the Exchange Rate Mechanism that we will see later on) were not allowed to float freely against each other between the early 1970s (end of Bretton Woods) and the Euro inception day (1999). Hence, it is hard to believe that European Leaders will let the currency down by accepting a country to leave the Euro Zone (i.e. Greece or Italy) because for the main reason that it has been a Political project for more than 60 years.

Although it would take me more than a life-time to precisely study step by step the creation of European Union after WWII, this part will only focus on a few important political events that will be useful for a FX history research.

A. Introduction: Post WWII ‘cluster’

So the first international organisation to unify six Continental European countries after WWII was called the European Coal and Steel Community (ECSC) and was established in 1951 by the Treaty of Paris (signed by France, Belgium, West Germany, Italy, the Netherlands and Luxembourg). In 1958, the Treaty of Rome came into place (signed by the same six countries in March 1957) and created the European Economic Community (ECC). It still remains one of the most important Treaties of the EU history; in short, it proposed the progressive reduction of customs duties, the establishment of customs union and the creation of a single market for goods, labour, services and capital. Alongside the ECC, the European Atomic Energy Community was established by the Euratom Treaty, with the purpose of creating a specialist market for nuclear power in Europe in addition to energy development and distribution.

As you can see it on the ‘history map’ (Picture 1), between 1958 and the early 1970s, the European Union was ‘represented’ by three Communities (ECC, ECSC and Euratom), which eventually merged in 1967 (Brussels Treaty) to form a single institutional structure.

Until the early 1970s (end of Bretton Woods: 1971 – 1973), all the six countries were part of the Bretton Woods system, therefore there wasn’t any ‘action’ in the FX market then. You can see below at which rate the currencies were pegged to the US Dollar (table 1).

Table 1. Exchange Rates versus the US Dollar during the three Communities (Source: Bloomberg)

Countries	Currency vs. 1 unit of USD
West Germany (DEM)	3.64
French Franc (FRF)	5.52
Italian Lira (ITL)	623
Luxembourg Franc (LUF)	49.70
Belgium Franc (BEF)	49.70
Dutch Guilder (NLG)	3.5950

B. The 1970s: after the Nixon Shock.

The Nixon announcement – convertibility suspension of USD into gold – on August 15^th 1971 was followed by the Smithsonian Agreements signed by the Group of Ten (or G-10) in December 1971. In short, the countries accepted a US Dollar devaluation of roughly 8% against Gold (from $35 to $38 an ounce), wider trading bands of 2.25% (vs. 1% before) and some [countries] agreed to sharply appreciate their currency against the US Dollar (JPY + 16.9%, DEM and GBP +13.6%, FRF +8.6% and ITL +7.5%). This agreement’s objective was to devalue the US Dollar in the time when the US was running negative balance of payments and important deficits as a consequence of the Vietnam War and the Great Society program (launched by President Johnson in the mid-60s, the aim was the elimination of poverty and radical justice).

However, under these new [but smoother] restrictions, the snake in the tunnel was adopted in attempt to limit fluctuations between EEC currencies. As a reminder, during the Smithsonian Agreement, EEC currencies were allowed to trade within a 2.25% band against the US Dollar. This means that if the Italian Lira started suddenly to depreciate from the low of its band to the high of its band, this would result in a total 4.5% depreciation against the US Dollar. On the other hand, if the Deutsche Mark started to appreciate from the high to the low of its band, this would result in a total 4.5% appreciation. Therefore, if both happened simultaneously, the Deutsche Mark would appreciated by 9% against the Italian Lira. The Basel agreement (April 10^th 1972) judged that the movement was too excessive and set a maximum change of 4.5% between two EEC currencies as well.

Even though it bought the US some time to regain some competiveness in the market after the Agreement, the US Dollar continued to fall dramatically in the 1970s (as a response to inflation rising from the two oil shocks) and countries were forced to quit the currency snake. For instance, the British Pound, which joined the snake in May 1972, left it a couple of months later. Italy left the snake in January 1973, followed by France in 1974 and again in 1976 after joining back. By 1977. The currency snake became a ‘Deutsche Mark zone’ with four trackers: Belgium and Luxembourg Francs, the Dutch guilder and the Danish Krone (that joined the EEC on January 1^st with Ireland and United Kingdom).

As we can see, depriving currencies to fluctuate freely between each other under the Currency Snake was a failure in the 1970s, but it didn’t stop the ECC officials to continue to work on a European Monetary System.

C. 1979: The European Monetary System

In March 1979, with the adoption of the European Monetary System (EMS) under the Jenkins European Commission, all nations of the EEC (Except United Kingdom) agreed to link their currencies under the Exchange Rate Mechanism in order to prevent large fluctuations and achieve monetary stability across in Europe. Picture 2 shows the historical exchange rate regimes for European Countries since 1979:

The colour Grey represents members of the ERM (currency pegs to ECU)
The colour Blue represents the members of the Euro Zone ( 19 countries)
The colour Yellow represents countries members of the European Union, but outside of the ERM. For instance, Croatia joined the EU in 2013 but still has a ‘floating’ exchange rate (though it looks like the Croatian Monetary Authority has been trying to set the exchange rate at 7.6 HRK against the Euro with a trading band of roughly 2%)
The colour Green represents members of the EU, outside the ERM but with a currency pegged to the Euro (i.e. Bulgarian Lev BGN is set at 1.96 per unit of EUR)

Under the EMS arrangement, the European Currency Unit (ECU) – a basket of the currencies of the European Community members – was defined and used as the unit of account before becoming the Euro in 1999. Even though no currencies was designated as an anchor, the Deutsche Market (along with the Bundesbank) became the centre of the EMS very quickly (DEM had other 30% of currency weigh to the ECU between 1979 and 1999, followed by France with 20%). Therefore, in the 1980s, the DEM, the GBP and the USD became three main currencies traded by market participants (an interesting documentary about currency trading called ‘Billion Dollar Day’ was produced by the BBC in 1985 and looks at one day – 24 hours – of FX trading).

As you can see it in picture 2, two countries had to withdrew from the ERM due to economic policies divergence and speculative: Italy withdrew from ERM on September 17^th 1992 after a 7-percent devaluation 4 days earlier (re-entered in Q4 1996) and the UK withdrew from ERM on September 17^th 1992 after Black Wednesday a day earlier (and never re-entered).

In addition, broad margins were also increase to 15% in August 1993 to allow currencies to accommodate speculation against other currencies (French Franc in 1992-1993).

D. The Maastricht Treaty

Before switching to Euro’s birth and the single currency potential drivers, another important Treaty signed on February 7^th 1992 was the Maastricht Treaty, which created the European Union and led the creation of the Euro. It set the convergence criteria for a country to qualify for participation in EMU, which are the following ones:

Inflation within 1.5 percent of the best three countries of the EU for at least one year
Nominal long-term interest rates are required to be within 2% points of the best three in the EU for at least a year
Applicants countries have to be in the ‘narrow’ band of the ERM-II without tensions (and depreciation) for at least two years
Fiscal discipline: a budget deficit to GDP ratio of nor more than 3 percent and government debt-to-GDP ratio of no more than 60%

The treaty entered into force on November 1^st 1993 and has been amended by the treaties of Amsterdam, Nice and Lisbon since then.

II. Study of trends, reversals and main drivers of the single currency since Inception

A. January 1^st 1999: the launch of the Euro and the constant three-year depreciation

After four decades of effort, the single currency was born virtually in 1999 and in 2002 coins and notes began to circulate. At that time, there were 11 members and the US Dollar was trading at an initial value of 1.1685 against the Euro (the pound was buying roughly 1.42 euros at that time). However, the single currency suffered three years of depreciation against the US Dollar after its launch and hit an historical all-time low of $0.8230 in October 2000 according to Bloomberg data (chart 1).

There have been many explanations for the Euro 1999-2002 depreciation; some economists used the productivity differential to explain the USD/EUR exchange rate (Corsetti and Pesenti, 1999, Chinn and Alquist, 2002 Schnatz et al., 2004), others used a set of macroeconomic variable – growth rate, inflation differentials, current accounts – (De Grauwe, 2000, De Grauwe and Grimaldi, 2005), or a surge in the equity market capitalization in the US since the mid-1990s leading to a large positive demand shock and a US Dollar appreciation (Meredith, 2001). Even though these explanations could be convincing broadly financially speaking, most of them fail to explain the Euro weakness (vs. the US Dollar) empirically. Therefore, the depreciation of the Euro from 1999 to 2002 remains a puzzle and a fair conclusion to that depreciation period could be that the single currency wasn’t perceived as a full-pledge money by consumers and investors until the introduction of Euro coins and notes in 2002 (Shams, 2005).

B. The 2002 – 2008 appreciation

After notes and coins came into circulation (and National banknotes and coins were finally withdrawn from use), the Euro started its appreciation period against the greenback and almost double in value in 7 years; it soared from a historical low of 82.30 cents vs. USD to a historical high of $1.6040 reached in July 2008.

As the Euro Area GDP quickly reached 10tr USD in 2004 (vs. 12.5tr USD for the US at that time), it became the second world’s largest economy and therefore the importance of the Euro as an international currency was starting to increase. There are several explanations to the Euro appreciation against the USD:

Divergence in the Current Accounts

Between 2000 and 2007, the US Current Account deficit widened from 4% to 7% of the country’s GDP (appendix 1), while the EZ Current Account was improving and slightly positive (+1% of GDP in 2004).

The large CA deficits could have been partially explained by the fact the US has a low savings rate (Summers, 2014); the deterioration of the national saving rate (percentage of GDP that entities in an economy such as households, businesses and governments themselves save over a fixed period of time) between 1990s and 2000s has led to increase in the current account deficits in the US (a current account deficit is the difference between national savings and national investments, the deterioration of the national savings).

A Weak US Dollar

This period was also associated with a long weak US Dollar period. The greenback was not only depreciating against the Euro, but most of the currencies (Cable rose from $1.40 to over 2.10$ during the same period; USDJPY went down from 120JPY to 70JPY…). This period was also very significant for commodities; gold soared $300 to $1,000 an ounce while oil went up from $18 to over $140 a barrel.

Interest rate differentials

Another explanation relies the interest rate differentials between Europe and the US; as European interest rates were relatively high compared to US interest rates, it attracted capital inflows in Europe and therefore contributed to the Euro strength.

Strong European growth

During the 2002-2008 period, the Euro Zone was experiencing strong growth – especially between 2006 and 2008 – and was the engine of global demand growth. Housing and Consumption bubbles in many peripheral countries (Spain, Portugal, Ireland…) generated the so-called positive feedback loop and fuelled its growth.

In many ways, it looked like [during that period] the Euro Zone was stepping into the role of the US had previously played in the global economic system. Some even argued if the single currency will eventually surpass the Dollar as the Leading international currency (Chinn and Frankel, 2005). In their paper, the authors stated that if the US Dollar depreciation persisted in the future and if an important member joined the EMU (i.e. the UK), the Euro may have surpassed the Dollar as a leading international reserve currency by 2022.

C. The 2008 GFC and the Dollar rise.

In the summer of 2008, investors started to look for safety as the threat of a global failure in the system was starting to emerge sharply. Due to the search for safe-havens, both the global flight to safety into US Treasuries and the reversal of the carry trades were sources of Dollar strength. The Euro lost 23% (and 34% resp.) against the US Dollar (v. the Japanese Yen resp.) between the summer 2008 and Q1 of 2009 (chart 1).

In addition, the dollar asset writedowns left European banks and institutional investors outside the US with overhedged dollar books; therefore, squaring their positions required those institutions to purchase US Dollars, and therefore boosted the greenback’s appreciation (McCauley & al., 2009). In those panic moments, investors tend to look for safe-havens and the first questions that come to their minds are: What’s cheap and what’s liquid? The fact that investors bought US Dollar (and Treasuries) in the turn of the year 2000 (after the dotcom bubble popped) played also an important behavioural empirical bias.

To conclude, there was also a dollar shortage after Lehman’s failure in September 2008 that reflected unbalance growth in international banking. As the BIS explained, European banks accumulated dollar assets well beyond their dollar deposits and funded the difference in the interbank market. The banking system suffered from a dollar shortage and the incredible spike in the 1-month and 3-month Yield premium in US Dollar swaps (Figure 1) contributed to a sharp appreciation of the US Dollar.

C. Post GFC: Sovereign Debt Crisis, ‘twin’ deficits, bailouts….

After the 2008 financial crisis [and before May 2014], three major drivers could explain the EURUSD dollar fluctuations:

The spreads between peripheral and core Euro Zone countries (the first popular one to arise was the German-Greece 10-year spread in 2009/2010, then the second one was the German-Spanish 3-year spread during 2011/2012).

The ECB-Fed total-asset ratio: looking at the central banks’ balance sheets have become popular after 2008 (see article it is all about CBs), and therefore the ratio between the ECB and the Fed’s balance sheet total assets was an important indicator to look at during that period. The higher the ratio (ECB balance sheet is increasing relatively to the US one), the weaker EURUSD.

The last indicator was current account differences (between US and EZ). As a consequence of the financial crisis, peripheral European countries were left with massive current account deficits – i.e. 15% in Greece or 13% in Portugal – which obviously accelerated the outflows from Europe and depreciated the currency.

On the top of that, after the establishment of a rescue fund (EFSF and EFSM first, then the ESM in 2012) to assist countries that couldn’t borrow from the market, it took some time for market participants to ‘digest’ it as there was speculation that the maximum lending capacity of €500bn was clearly not enough if EZ countries were falling one by one. More and more countries were considered as recipients [of an ESM bailout] and less and less countries were considered strong guarantors; the Euro Zone was constantly making the headlines between 2009 and 2012 which was each time impacting the Euro.

2011 first shot: introduction of new LTROs

In response to the European sovereign debt crisis, the ECB announced a new ‘version’ the long term refinancing operation (LTRO) – a cheap loan scheme for European banks – towards the end of 2011. By definition, the LTROs provide an injection of low interest rate funding to euro zone banks (using sovereign debt as collateral on the loans) and are used to provide longer-term liquidity than standard MROs (main refinancing operations) to banks during times of crisis. Before the financial crisis, the ECB’s longest tender offered was just three months and represented about 20% of the ECB’s liquidity provided. After the crisis hit, the maturity of these LTROs was extended to six months (March 2008) and 12 months (June 2009).

Then, the two rounds that were carried out in December 2011 and February 2012 were expanded to a three-year maturity with a 1% interest rate and the option of repayment after one year. In total, the ECB LTROs provided more than 1 trillion euros of liquidity to euro zone banks to stave off the credit crunch and on hopes that the situation improves (i.e. decrease in peripheral yields).

But the situation deteriorated;, the Euro went down from a lower high of 1.50 (against the US Dollar) in mid-2011 to retest the $1.20 in the summer of 2012 (chart 1). At that time, the ECB balance’s sheet was expanding (thanks to the LTROs) and reached a high of €3.1 trillion in June 2012 (chart 2) while the Fed’s balance sheet was steady after QE2 ended in June 2011 (Operation Twist lasted from September 2011 to December 2012 but didn’t increase the size of the central bank’s balance sheet). In addition, peripheral yields of European countries rocketed during that period; the Italian and Spanish 10-year bond yields were trading at 6.5% and 7.5%, respectively, in the summer of 2012. Investors started to worry that the ESM rescue fund wasn’t strong enough to support countries like Spain or Italy and were starting to fear potential defaults coming ahead. This was clearly not sustainable; Italy was (and is) not able to roll its obligations at a 6%+ yield without and the markets needed a reaction at that time.

2. July 2012: ‘Whatever it takes’ and the introduction of the OMT program

Therefore, that leads us to the famous Draghi’s ‘whatever it takes’ at an investment conference in London on July 26^th 2012 (and the extra comment ‘we think the euro is irreversible’) with the introduction of the OMT (Outright Monetary Transactions) program on August 2^nd. Even though the OMT was [and still is] considered as a myth by many practitioners and economists, it was ‘enough’ to reverse the trend on peripheral European bond yields, and therefore the Euro. Until May 2014, the Euro became one of the traders’ favourite currencies (with the British pound); click here if you want to read an article that we wrote in February 2014 (The Euro Strength and the ECB’s options) that explains more in details the appreciation of the Euro.

However, in a world where every economy wants a cheap currency, the Euro strength was starting to pause a problem for EZ politicians and policymakers, as inflation expectations were falling towards zero. The 5Y5Y inflation swap rate fell below the 2-percent level (the ECB’s target) in 2014 as you can see in chart 3, increasing doubts on the ECB only mandate. In addition, the Euro strength was causing competitiveness problems for peripheral countries.

D. May 2014: ‘Ready to Act’ and the end of a Euro love story

On May 8^th 2014, Draghi announced during his conference that the ECB was comfortable with taking new fresh action (i.e. QE + Negative interest rate policy) at the next meeting in June in order to tackle the lowly inflation rate (and send the Euro down). After that meeting, the ECB decided to go all-in in the next few months and entered into the Currency War Game. At that time, US monetary policy and European monetary policy flipped at the same time (chart 2): while the Fed was tapering its QE3 by 10-billion dollars every month, the ECB announced the market that it will take further measures. The reaction on the Euro was imminent, and the single currency went down from a lower high of 1.40 during that meeting (May 8^th) to close at a low of $1.21 at the end of the year 2014.

At the June ECB meeting, Mario Draghi announced a series of measures [as promised] that included cutting the deposit rate into negative territory (-0.10%), targeted LTROs, an extension of the fixed rate full allotment and preparation of European QE. The ECB ‘bazooka’ was finally announced on January 22^nd 2015, planning monthly purchases of €60bn of private and public sector debt between March 2015 and September 2016 (bringing the QE size to 1.1tr Euros). The expanded asset purchase program (APP) – i.e. QE – is split in four different categories, which are (ECB website):

Third covered bond purchase programme (CBPP3)
Asset-backed securities purchase program (ABSPP)
Public sector purchase programme (PSPP)
Corporate sector purchase programme (CSPP)

The Euro continued its negative trend against the US Dollar to hit a low of $1.0450 in March 2015; since then, the pair has been oscillating mainly within the 1.05 – 1.15 range (chart 1), with the exception during the August 24 flash crash in 2015 where the Euro soared with the VIX and rose above 1.17 against the US Dollar. One explanation of the positive 20-day correlation between EURUSD and VIX index (see article here) could be that investors holding European assets such as stocks or bonds (in response to more stimulus) were all hedged (i.e. short EURUSD). Therefore, when the market crashed in August 2015 (Eurostoxx 50 plummeted 20%, chart 4), investors had to buy back Euros in order to not be overhedge, therefore pushing the Euro to higher levels.

III. Current state of the Euro

A. Where do we stand now?

Despite further rate cuts in the deposit rate (-0.4%), an increase in the size and the duration of the QE programme to €80bn and now due to run until March 2017, the Euro has remained flat. Since the beginning of 2015, the Euro has been fluctuating around 1.10 against the dollar, a level which seems to correspond to the ‘fair value’ of the single currency.

The ECB balance sheet has grown to a historical high of 3.5tr EUR, and there are talks that EZ policymakers could run out of paper to buy within the next 12 to 18 months. Figure 2 represents the ECB weekly purchases under the APP program; the central bank usually releases its latest bond purchase data every week by submitting its lists of ISINs. As of October 14^th 2016, the total CSPP holdings stood at €33.8bn.

As you can see it on chart 3, despite a 1.5 trillion EUR increase in the ECB balance sheet’s assets, the 5Y5Y inflation has constantly trend lower and now stands at 1.46%. In addition, based on the September macroeconomic projections, the central bank cut its growth outlook for 2017 and 2018 to 1.6% (vs. 1.7%) and its inflation 2017 forecast to 1.2% (vs. 1.3%) as a consequence of Brexit vote.

B. How to weaken the Euro?

As we said earlier, the single currency hasn’t been responding to fundamentals nor core-peripheral spreads since the implementation of QE. we are not part of the school that thinks the Euro needs to be weaken even more, however here are a few factors that could bring the single currency to lower levels in the near future. The first one is political uncertainty rising in Europe; for instance the first event to come is the Italian Constitutional referendum that is planned to be held on December 4^th. As you can see on chart 5, the 10-year Italy-German yield spread has surged from 110bps to 160bps (back to post Brexit levels) over the past three months. If the divergence continues to increase ahead of the referendum, the market could react to a potential contagion in Europe and therefore the IT-GE 10-year spread could serve as a proxy of the current political uncertainty in Europe.

The second one comes from a Dollar rise based on a confidence that the Fed is considering starting [again] its monetary policy tightening cycle. The last rate increase was in December last year (25bps), however the market didn’t react very well (SP500 index was down by 13% in January) and the global macro situation in early 2016 (low oil prices, decreasing earnings…) kind of forced the Fed to pause. If we look at the FedWatch Tool (appendix 2), the implied probability of a potential hike stands at 71.5% for the December meeting. Even if we see a rate hike in December, we don’t think the USD reaction will be too significant; EURUSD may trade a 150 / 200 pips lower than its current value, which corresponds to the lower band of this year trading range.

A third reason to think of a Euro depreciation would be that the ECB suddenly announces that it will purchase stocks (like in Japan, there were talks of a potential 400/450bn EUR ETF program). The European Stock market (i.e. Eurostoxx 50) has been a dead market for the past year, oscillating around 3,000 in good times with sharp drawdowns each time a non-priced event occurred (December-February 25% sell off after the Fed’s hike last year, 13% sell off after Brexit news…). It now stands at the same level of the QE announcement in January 2015 (see chart 4).

We think that the first scenario (widening spreads between Italy and Germany and political uncertainty rising in Europe) is the most probable one. we would keep a downside view on the Euro ahead of the Italian referendum with a potential first target at 1.08.

Picture 1. History map of the European Treaties and Communities (Source: Wikipedia)

Picture 2: Exchange-rate regimes for EU members starting 1979 (Source: Wikipedia)

Chart 1. EURUSD historical monthly candlesticks (Source: Bloomberg)

Chart 2. ECB (white and blue line) versus Fed (yellow line) balance sheet (Source: Bloomberg)

Chart 3. ECB balance sheet (White and Blue line) overlaid with 5Y5Y forward inflation rate (Yellow Line) (Source: Bloomberg)

Chart 4. EuroStoxx historical daily prices since QE announce (Source; Bloomberg)

Chart 5. German versus Italian 10-year yield spread (Source: Bloomberg)

Figure 1. Libor and Dollar swap yield premium (Source: BIS)

Figure 2. Weekly purchases under the expanded APP (Source: UBS, ECB)

Appendix 1. EZ (top) and US (bottom) current accounts (% GDP) (Source: Trading Economics)

Appendix 2. FedWatch Tool – Probability of rate hike in December (Source: CME)

Eyes on Yellen (and global macro)

June 15, 2016May 10, 2018 RothkoResearchLeave a comment

As we are getting close to the FOMC statement release, we were reading some articles over the past couple of days to understand the recent spike in volatility. Whether it is coming from a ‘Brexit’ fear scenario, widening spreads between core and peripheral countries in the Eurozone (German 10Y Bund now trading negative at -0.5bps), disappointing news coming from US policymakers this evening or more probably from something that we don’t know, we came across some interesting data.

First of all, we would like to introduce an indicator that is getting more and more popular these days: Goldman’s Current Activity Indicator (CAI). This indicator gives a more accurate reflection of the nation’s GDP and can be used in near real-time due to its intra-month updates. It incorporates 56 indicators, and showed a 1-percent drop in May to 1.2% due to poor figures in the labor market and ISM manufacturing data (see chart below).

Chart 1. Goldman CAI (Source: Bloomberg)

The implied probability of a rate hike tonight is less than 2% according to the CME Group FedWatch, and stands only at 22.5% for the July meeting. If we have a look at the Fed Dot Plot’s function in Bloomberg, we can see that the implied FF rates curve has decreased (purple line) compare to where it was after the last FOMC meeting (red line), meaning that the market is very reluctant to a rate hike in the US.

Chart 2. US Feds Dot Plot vs. Implied FF rates (Source: Bloomberg)

June hike, why not?

Many people have tried to convince me of a ‘no June hike’ scenario, however we try to understand why it isn’t a good moment for Yellen to tighten. Oil (WTI CL1) recovered sharply from its mid-February lows ($26/bbl) and now trades slightly below $48 (decreasing the default rate of the US high-yield companies), the US Dollar has been very quiet over the past 18 months (therefore not hurting the US companies’ earnings), the SP500 index is still trading above 2000, the unemployment rate stands at 4.7% (at Full employment) and the Core CPI index came in at 2.1% YoY in April.

However, it seems that US policymakers may have some other issues in mind: is it Eurozone and its collapsing banking sector, Brexit fear (i.e. no action until the referendum is released), CNY series of devaluation or Japanese sluggish market (i.e. JPY strength)?

The negative yield storm

According to a Fitch analysis, the amount of global sovereign debt trading with negative yields surpassed 10tr USD in May, with now the German 10Y Bund trading at -0.5%bps. According to DB research (see chart below), the German 10Y yield is the ‘simple indicator of a broken financial system’ and joins the pessimism in the banks’ strategy department. It seems that there has never been so much pessimism concerning the market’s outlook (12 months) coming from the sell-side research; do the sell-side firms now agree with the smart money managers (Carl Icahn, Stan Druckenmiller, Geroge Soros..)?

Chart 3. German 10Y Bund yield (Source: DB)

ECB Bazooka

In addition, thanks to the ECB’s QE (and CSPP program), there are 16% of Europe’s IG Corporate Bonds’ yield trading in negative territory, which represents roughly 440bn Euros out of the outstanding 2.8tr Euros according to Tradeweb data. If this situation remains, sovereign bonds will trade even more negative in the coming months, bringing more investors in the US where the 10Y stands at 1.61% and the 30Y at 2.40%. If we look at the yield curve, we can see that the curve flattened over the past year can investors could expect potentially LT US rates to decrease to lower levels if the extreme MP divergence continues, which can increase the value of Gold to 1,300 USD per ounce.

Chart 4. US Yield Curve (Flattened over the past year)

(Source: Bloomberg)

Poor European equities (and Banks)

However, it seems that the situation is still very poor for European equities, Eurostoxx 50 is down almost 10% since the beginning of June, led by the big banks trading at record lows (Deutsche Bank at €13.3 a share, Credit Suisse at €11.70 a share). The situation is clearly concerning when it comes to banks in Europe, and until we haven’t restructured and/or deleveraged these banks, systemic risk will endure, leaving equities flat (despite 80bn Euros of money printing each month). Maybe Yellen is concerned about the European banks?

Brexit?

Another issue that could explain a status quo tonight could be the rising fear of a Brexit scenario. According to the Brexit poll tracker, leave has gained ground over the closing stages, (with 47% of polls for ‘Brexit’ vs. 44% for ‘Bremain’). This new development sent back the pound to 1.41 against the US Dollar, and we could potentially see further Cable weakness toward 1.40 in the coming days ahead of the results. Many people see a Brexit scenario very probable, raising the financial and contagions risks and the longer-term impact on global growth. It didn’t stop the 10Y UK Gilt yield to crater (now trading at 1.12%, vs. 1.6% in May), however a Brexit surprise could continue to send the 5Y CDS to new highs (see below).

Figure 1. FT’s Brexit poll tracker (Source: Financial Times)

Chart 5. UK 5Y CDS (Source: Bloomberg)

CNY devaluation: a problem for US policymakers?

Eventually, another problem is the CNY devaluation we saw since the beginning of April. The Chinese Yuan now stands now at its highest level since February 2011 against the greenback (USDCNY trading at around 6.60). we are sure the Fed won’t mention it in its FOMC statement, but this could also be a reason for not tightening tonight.

Conclusion: a rate hike is still possible tonight

To conclude, we are a bit skeptical why the market is so reluctant for a rate hike this evening, and we still think there is a chance of a 25bps hike based on the current market situation. We don’t believe that a the terrible NFP print (38K in May) could change the US policymakers’ decision. Moreover, even though we saw a bit of volatility in the past week (VIX spiked to 22 yesterday), equities are still trading well above 2,000 (SP500 trading at 2,082 at the moment) and the market may not be in the same situation in July or September.

June rate hike? What Yellen (and the Fed) faces…

April 21, 2015April 21, 2015 RothkoResearchLeave a comment

I have to admit that by just looking at the government bond yields (see appendix), I am asking myself a lot of questions about the stability of the economy and the financial markets. However, one particular point that matters the most is the Fed’s June rate hike.

Therefore, this article aims to give an update on the four major risks that can lift-off the central bank’s monetary policy decision for later this year, which are the following topics:

China slowdown
Dollar strength
Oil prices
Grexit: Greece and all its 2015 payments

China Slowdown

It is clear that commodity prices have dropped dramatically over the past year based on a lower than expected Chinese growth (i.e. global demand). If we look at the last figures, analysts expect China to grow by approximately 7% in 2015, down from the last 7.5% projection (in late 2014). Last week, we saw that the economic output grew 7% YoY in the three months of 2015, down from 7.3% in Q4 last year and now standing at its slowest rate in six years. What really concerns me is that I read several times the word ‘approximately’ in analysts predictions of China 2015 growth, this means that we could see an actual lower than 7% figure, especially in the middle of this geopolitical war.

In the housing market, it looks like the economy is experiencing a sort of ‘real’ correction: if we look at on of Chinese Housing Market ‘benchmark’ – China 70-city Home price change – the last report showed that house prices decreased 6.1% YoY in March, its eighth negative print in a row and the biggest drop in history.

It is hard to believe that after a 15tr USD increase in total Chinese Bank assets since September 2008, the economy is still struggling to achieve a healthy growth. The obvious response from Beijing officials was to cut its Reserve Requirements Ratio by 1% to 18.5% (last one was a 50bp cut in early February), ‘flooding the market’ with liquidity and participating – like the rest of the World – to this massive monetary stimulus.

What the PoBC cut a sort of ‘preparation’ to the Fed’s action?

Maybe I know too little about the Chinese economy (and history), but it is curious too see that some financial experts have a totally different interpretation of China.

For instance, in the last discussion that I had with a (very) experienced economist, I asked him ‘Where do you see the most interesting opportunities at the moment for medium term investments?’

He answered me: ‘Well, there are three countries you should invest in: China, China and China!’ He started his quick analysis about the massive internal migration of young new dwellers moving from rural to towns and cities (between 10 and 20 million each year according to NBS). Chinese major cities will host approximately 60% of the country’s total population (permanent urban residents) by 2020 (slightly above 50% now), therefore playing in favor of Chinese Fixed assets, companies’ valuation,… However, I was asking myself: ‘What about work conditions and salary increase? We learned from the last GFC that you can’t reach a sustainable economy with a divergence between median annual incomes and home prices. In addition, you can’t build a strong economy based on speculative stories and artificial growth (look at the Spanish situation now after the correction in the housing market).

Moreover, this scenario was based on a strong assumption that relations between China and the US remain stable (i.e. no pressure from the West to abolish the exchange rate peg). This is clearly not obvious, especially in this new (sort of) Cold War between East and West. If we look at the US Treasury website, we can see that China has reduced its US Treasuries by 50bn USD over the past year (its US holdings stand at 1.224Tr USD as of February). If this trend continues, pressure from US officials to drop the peg will be more and more a serious debate.

Besides that digression, it seems that we are going to see some downward revision in China, which will obviously be a persistent topic at the next FOMC statements.

Dollar strength

The topic that I love to discuss is the Dollar strength. Described as the most crowded trade of the year, it is clear that a constant strengthening greenback will be problematic for the US economy, especially now that the Fed has stepped out of the bond market. Even though we saw a sharp reduction of the government’s deficit in the last two fiscal years (the annual US budget deficit fell from 1.1tr USD for FY12 to 483bn USD for FY2014 as you can see it in the chart below – equivalent to 2.8% of the country’s GDP), the US still runs large current account deficits (coming from consistent trade deficits) which forces them to rely on external funding.

(Source: WSJ)

A strong dollar wouldn’t help to ‘redress’ the balance of trade (i.e. exports are less competitive), and will obviously decline companies’ sales and reduce the economic output. Pessimist Atlanta Fed forecast a zero-percent growth for the first three months of this year, down from 1.9% in early February. The market is more bullish anticipating a 1.4% rise.

The July Fed Funds Futures implied rate is at 15bp, while September and December are trading at 21bp and 34.5bp respectively. From that perspective, I will opt for a September move (vs. June).

Oil prices

As you know, oil prices fell sharply in the second half of last year, bringing to an end a four-year period of stability around $105 per barrel. If we look back at prices’ history since the early 80s, there has been four other relevant declines prior to this one:

Increase in oil supply and change in OPEC policy (1985-86)
US recessions after the S&L crisis in 1990-1
The Asian crisis of 1997
The Great Financial Crisis 2007 – 2008

Today, the causes of the Sharp Drop could be explained by multiple factors: a change in OPEC policy objectives (no intervention from Saudi Arabia in the last OPEC meeting on November 27^th last year), increasing production (US Production of Crude Oil now stands above 9ml barrel/day, up from 5ml 7 years ago post GFC), receding geopolitical concerns about supply disruptions in the Middle East and between Russia and Ukraine, a sinking global demand and a US dollar appreciation. It is hard to define which of these factors was the most important, however I would say the expansion of oil output in North American due to the US Shale revolution (and Canada oil sands) and a declining global demand both weighed on oil prices.

Although low oil prices (and other commodities) is seen as a sort of stimulus for consumers by analysts, I am very confident that it is also the explanation of the late decrease in inflation expectations in all the Western countries. The table below shows you the Consumer Price Index of the major economies:

Country	March	July
US	-0.10%	2.00%
UK	-0.10%	0.40%
EZ	0.00%	1.60%
Japan	2.2% (February)	3.40%

Even the 5y/5y forward swap rate, what central banks watch as an indication of inflation expectations, has fallen to unprecedented sub-2 percent levels in the US, which is going to be problematic as Yellen and (most of) the Fed’s Board have considered that it is time for monetary policy tightening – the so-called neutrality.

In addition, low oil prices could also be a burden for all the high leveraged shale oil companies in the US. The chart below (source Bloomberg) gives us a quick idea of where oil prices have to stand so that shale companies are (at least) breakeven. According to the sell side research, breakeven prices for US shale oil are within the $60-$65 window. WTI May futures contract is still trading below those figures at a shy $56.

(Source: Bloomberg)

Grexit and the contagion effect

With the 10-year yield now trading at 13% (and the 2Y at 29%), it is clear that the market is anticipating disappointing negotiations between the new Greek party and the Troika. There are lots of good articles that came out lately about Greek’s situation, but that could easily be summarize by the chart below. This clearly shows that there are going to be a lot of meetings with European officials before the Summer, and the Tsipras government will have to innovate its list of reforms in order to free up funds and service its short-term obligations.

(Source: IMF)

What’s next then? Let’s assume Greece makes it way through the summer (the two 3bn+ payments to the ECB) without catching a cold, this is only the 2015 chart and there are plenty of more years to come. No borrowing from the financial market and an unstoppable increasing debt (see article Pocketful of Miracles). A situation that could only deteriorate in my opinion…

In the latest news, Bloomberg reported that the Greek government issued a legislative act yesterday that requires public sector entities to transfer idle cash reserves to Bank of Greece (i.e. capital controls) as the country is willing to serve its next €1bn debt obligations to the IMF next month.

To conclude, we may see a symbolic 25bp hike at the June FOMC meeting, however I am certain that we are far from the so-called long-run neutrality rate of 3.5%-4%. If the weak global macro environment persists in the medium term, we are constantly going to see downward revision in the Fed’s dot plot.

Appendix: Government bond yields

January 2015: A Rough Start

February 2, 2015February 2, 2015 RothkoResearchLeave a comment

The past month has been quite eventful in the financial market and I am sure that some of the decisions (if not all) surprised many of us. After the SNB announce on January 15th, the ECB took over and unveiled a €60bn monthly QE (not open-ended) through September 2016; so 19 months at €60bn equals €1.14tr. The ECB, which has already been buying private assets such as covered bonds (a safe form of debt issued by banks) and ABS, will add an additional €50bn worth of public debt (bonds of national government and European institutions) to its current program starting in March this year. The purchases of these securities (in the secondary market) will be based on the Eurosystem NCB’s shares in the ECB’s capital.
In addition, President Draghi also added that the ECB will remove the 10bp spread on the TLTROs, and the interest rate applied will be equal to the rate on the Eurosystem’s MRO (5bp).

We saw on Friday that EZ preliminary inflation fell by 0.6% in January after a -0.2% print in December, the largest decline since July 2009 when prices also fell 0.6% following GFC.

The ECB decision(s) sent the Euro to newest lows last week, down to 1.1120 (11-year lows) against the greenback and below the 0.75 level (0.7440) against the pound. But more importantly, it sent a bigger amount of government debt in the negative territory (yields). According to JP Morgan, there is currently (approximately) €1.5tr of Euro area government bond with longer than 1-year maturity trading at negative yields over time, and a ‘mind-blowing’ €3.6tr of global government bond debt (nearly a fifth of the total) with negative yields as the chat below shows us. For instance, the entire 10-year Swiss curve is now negative.

(Source: JPMorgan)

Another interesting topic is of course the 3 consecutive rate cuts (in 10 days) by the Danish Central Bank, that lowered it deposit rate to a record low of -0.5% to defend its peg and keep the Danish kroner (DKK) close to 7.46 per Euro (ERM II since 1999). EURDKK went down below 7.43; we will see this week how much policymakers spent in January in order to counter a DKK appreciation (some reports estimated that the central bank had to sell more than DKK 100bn). As a consequence (of the NIRP policy), a local bank – Nordea Kredit – is now offering a mortgage with a negative interest rate.
I believe the Danish krone is a currency to watch (in addition to the CHF) this month if the situation in Greece deteriorates.

A Weak Swiss Franc…
Since the SNB surprise, the Swiss has remained weak against the major currencies, with USDCHF up 7 figures (trading currently at 0.93) and EURCHF up from parity to 1.0550. Analysts slashed their forecast for this year and are now predicting a recession (-0.5% according to the KOF Swiss Economic Institute). I like the chart below which shows the 12-month Probability of the top 10 countries to fall into recession in the coming months according to Bloomberg economist surveys.

(Source: Bloomberg)

Japan and JPY still under threat over the long-run
In Japan, the 10-year JGB yield rose by 9bp in the last 10 days and is now trading at 29bps. USDJPY tumbled below 117 overnight on Grexit comments and Chinese manufacturing PMI contraction in January (49.8 vs. 50.2 expected), breaking its 117.25 support and extending its trading range to 116 – 118.75. ‘Buyers on dips’ reversed the trend and the pair is now trading at 117.60.
If we look at the long-run perspective in Japan, late macro indicators showed us that Abe’s government will have to do more. Real wages are still declining and fell the most in almost 5 years and the economy has now entered in a triple-dip recession (0.5% contraction QoQ in Q3). On the top of that, inflation has been weakening for the past 8 months as energy prices (mainly weak crude oil) weight on Japanese core inflation rate.
In addition, we saw that Japan plans a record budget deficit for next fiscal year (starting April 1st 2015) to support the economy. FinMin Taro Aso reported that government minister and the ruling coalition parties approved a 96.34tr Yen budget proposal for FY2015/2016. And I believe that we haven’t reached the peak yet, as Japan’s aging population (i.e. increasing social security spending) will ‘force’ the government to print larger and larger deficits. The IMF predicts that the country’s debt-to-GDP ratio will increase to 245% in 2015. It clearly shows that the USDJPY trend is not over yet, and there is further JPY weakness (and USD strength) to come.

On the other side of the Pacific Ocean, the US economy cooled in the fourth quarter. After the 5-percent Q3 print, GDP expanded at a 2.6% annual pace in the fourth quarter (first estimate). Net exports was the largest detractor from Q4 GDP (-1.02%) as imports grew faster than exports. King Dollar continues to benefit from the global weakness with the USD index trading slightly below 95. The equity market still handles the Fed’s withdrawal from the Bond Market with the S&P500 trading around 2,000 (looks like it is out of energy though), while US Treasury yields are compressing to new lows. The 10-year and the 30-year yields are trading at 1.67% and 2.25% respectively (which is quite concerning), and it seems the trend is not over yet. In regards to the inflation rate (that plummeted to 0.8% in December), the Fed delivered a hawkish statement last Wednesday (‘strong jobs gains’, ‘solid pace’ for economy), however dropping the entire ‘considerable time’ sentence and adding ‘inflation is anticipating to decline further in the near term’. The implied rate of the December 2015 Fed Funds futures contract is trading 30bps lower at 41 bps, while the December 2016 implied rate decreased by 60bps to 1.05bps in the past 6 weeks.

An important topic to follow this month will be developments in Greece which are moving very fast since the election on Sunday (January 25) and Syriza’s victory. ECB council Member Erkki Liikanen said over the week end that Greece needs to negotiate a deal before February 28th (when the Greek support program EFSF expires after the 2-month extension approved in December).

Quick thoughts ahead of the Fed’s minutes…

November 19, 2014March 1, 2018 RothkoResearchLeave a comment

Last month (October 8^th), while many investors were quite confident on the US Dollar strength momentum, the minutes of the FOMC’s September 16-17 policy meeting clearly showed us a message from US policymakers.

If you ask me if we see a stronger dollar in the LT against most of the currencies, we would answer yes and without any doubt. we think the Fed is comfortable with a Dollar appreciation, however we strongly believe they want the process to be slow and gradual. Despite strong recent fundamentals (another NFP above the 200K level in October for the 9^th consecutive time, an annual 3.5% first Q3 GDP estimate, ISM Manufacturing PMI still above 50, Housing Start fluctuating around 1mio for the past year…), global economic issues will weigh on US policymakers this time.

Let’s start with the first issue: the decline in oil prices. December Crude Oil WTI futures contract (CLZ14) is down $30 since end-of-June’s high, now trading below the $75 level. While we mentioned in one of our previous article that the decline in oil prices will be problematic for a lot of OPEC countries (see article Oil Breakeven Prices), it is now entering into critical levels even for the US. We heard and read that low oil prices could be seen as a stimulus for consumers, however it is now at levels hurting US shale production. According to some experts, most shale oil fields breakeven is seen between $70 and $75 per barrel (see chart below from Barclays Research).

(Source: Barclays)

As a reminder, the US, now producing around 8.5 million barrels per day (8.65mio in August 2014 according to the Energy Information Administration), was expected to surpass Russia within the next 10 years and grow its production by 35% to approximately 11.5mio barrels per day (see chart below from the Wall Street Journal).

(Source: Wall Street Journal)

Therefore, if prices continue to fell, the party could end earlier than expected. In addition, lower oil prices will add pressure on inflation expectations and the 2-percent target that the Fed is watching desperately. Important figure to watch tomorrow, CPI inflation is expected to remain steady at 1.7% in November. Any print below that would create a bit of US Dollar weakness as traders will start to lose credibility on the quantitative definition of ‘considerable time’.

Speaking of disinflationary pressures, let me go to the second issue: Dollar strength. Back in the minutes, Fed officials mentioned that they saw ‘rising dollar as a risk to exports and growth’. At that time, the USD index was trading at a 4-year high above the 86 level, and up 8.5% approximately since July low of 79.78. Today, the index is trading at even higher levels (87.60), thanks to the BoJ and the Yen development and EM meltdown. We saw that September US trade balance printed its biggest deficit since April at $43bn (vs. $40.2bn consensus), up from $40bn the previous month, due to a decline in exports (down 1.5%). In our opinion, ‘Dollar strength’ will be one of the topics tonight, therefore we could see some dollar weakness after the release. In addition, Dollar strength will also weigh on inflation expectations in the US (we don’t think the inflation effect of dollar appreciation is negligible, especially couple with lower oil prices).

Therefore, we see a bit of disappointment this evening, and we will encourage some of the US Dollar bulls to cut some of their long positions. The Euro and especially the British pound could recover from their recent losses, technical resistances are seen at 1.2670 and 1.5800 respectively.

Recovery mode after market turbulence

August 13, 2014March 1, 2018 RothkoResearchLeave a comment

Markets have been pretty shy this week, with equities recovering after two weeks of ‘correction’.
The S&P500 found support slightly above the 1,900 level on Friday after a 4.35% decline since July 24 high of 1,991.39. Market sentiment worsened as Obama launched another Iraq Assault, with traders potentially willing to put on some bearish positions; however it seems to me that markets don’t seem to be able to handle increasing risk well. AUDJPY eased 150 pips to find support at 94.40, which means that we reached our target of 94.60 based on our previous trade recommendation (see here).

(Source: Reuters)

Another sharp move was in the German market with the benchmark DAX index (blue line) off more than 11% between July 2 high (10,032.28) and last Friday’s low of 8,903.49. If you add the French and UK benchmark indexes (FTSE100 in red and CAC40 in orange), you can see that they had approximately the same path (see graph below), both down 4.3% and 7.5% respectively.

(Source: Reuters)

The single currency remains under pressure after last week equities sell-off and disappointing fundamentals. EURUSD is trading at a 9-month low, slightly below the 1.3350 level, after German ZEW survey came in well below expectations yesterday as geopolitical tensions and the sluggish recovery weigh on the European’s largest economy. Russia is one of Germany’s main trading partners, therefore there are signs that the German economy will grow at a lower rate than expected in 2014. As a reminder, final Q1 GDP came in at 0.8%; growth is expected to be flat on Q2 according to analysts’ first estimates.

Traders will watch EZ Q2 GDP first estimate and the final July CPI tomorrow, which are expected to come in at 0.1% QoQ and 0.4% YoY respectively. We are still bearish on EURJPY (entered at 137.20 with a MT target at 134.10), mainly based on a Euro weakness (ECB easing in addition to poor fundamentals).

Yen: The BoJ two-day meeting didn’t change any forecast on USDJPY, and the pair is still stuck within its 101-103 range for the past four months (couple of exceptions). Equities sell-off (Nikkei index down 1,000 pts between July 31 and Aug 8) combined with low US yields (10-year bottomed at 2.35% on Friday and is now trading slightly above the 2.40% level) played in favour of the JPY. USDJPY was sold to 101.50 on Friday and is now trading in the middle of its 200-range. Last night, we saw that Japan Q2 GDP collapsed by 6.8% according to Japan’s Cabinet Office (slightly less than the 7.1% expected), its worst contraction since 2011. While inventories additions added 1.0% growth, consumer spending fell 5.2% QoQ after the nation increased its sales tax from 5 to 8 percent on April 1^st. We will get back to Japan this week with an article focused on its economic outlook and what are BoJ policymakers’ options.

Markets after Yellen…

July 16, 2014March 1, 2018 RothkoResearch2 Comments

There have been some interesting developments for the past few days in the middle of this low-volatile environment. Firstly, Fed Chair Yellen opened two days of testimony on Capitol Hill yesterday, delivering the central bank’s semi-annual report to Congress. With the QE-Taper to end in October (already priced in), the market was waiting for more details concerning the ‘future path’ of the Fed Funds target rate (currently at a historical low of 0-0.25%). Despite strong employment data with Non-Farm Payrolls printing above the 200K level for the fifth month in a row in June (288K) and the jobless rate that edged down by another 0.2% to 6.1% (2008 levels), Yellen clearly stated that the US economic recovery ‘is not yet complete’ with the housing market showing ‘little progress’ but still disappointing this year.

However, she surprised the market a bit when she told the Senate Banking Committee that rates could rise sooner than planned. These comments ‘kind-of’ played in favour of the US Dollar, with USD index trading 80.50 at the moment. Its main component, the Euro (57.6%), broke out of his tight 1.3575 – 1.3675 range and is now trading at 1.3540 (see chart below). The next support on the downside stands at 1.3520, the 38.2% Fibonacci retracement of 1.2750 (July 2013 low) and 1.3992 (May 2014 high).

(Source: Reuters)

The second interesting development was the higher-than-expected CPI figures in UK that gave a boost to Cable after its last two weeks of weakening momentum. Annual inflation came in at 1.9% YoY in June (vs expectations of a 1.6% print), while CPI MoM increased by 0.2% (vs -0.1% consensus). It reinforced the market’s view that the BoE will be the first major central bank to lift rates. Even though some analysts are expecting a first move from UK policymakers later this year, we personally think that Q1 2015 sounds more reasonable. If we have a look at short-sterling interest rate futures, the March 2015 contracts sold off to 98.91 from 98.97, which means that the implied yield from 103bp to 109bp. Earlier this morning, UK claimant counts fell by 36.3K in June, following a revised 32.8K drop registered in May. The jobless rate edged down to 6.5% as expected.

After it reached a high of 1.7191 yesterday afternoon, Cable remains poised for a break above 1.7200 and is now trading at 1.7125. The first support on the downside stands at 1.7100, followed by 1.7060. A more interesting pair would be EUR/GBP, which is now trading at a 22-month low at 0.7900 and is approaching its next support at 0.7880 (see chart below).

(Source: Reuters)

Another surprise came from New Zealand where inflation accelerated less than expected, easing pressure on the RBNZ to continue its monetary policy tightening cycle. As a reminder, the central bank has increased its overnight cash rate (OCR) three times to 3.25% since the beginning of the year, and the market is still expecting a 25bps rate hike at the next meeting on July 23^rd. We felt that the Kiwi strength would probably weigh on NZ policymakers’ decision at the next meeting, therefore we were expecting a correction on NZD (see our last trade short NZD/JPY). It was also interesting to play a technical bear correction on NZD/USD when the pair was flirting with its 3-year high as you can see it on the chart below.

(Source: Reuters)

Quick update on BoJ and the Yen: USDJPY continues to trade sideways after the BoJ decided to keep its monetary policy unchanged (as expected), maintaining its target of increasing the monetary base at a annual pace of JPY60-70tr per year. The central bank cut its 2014 growth prediction to 1.0% (down from 1.1% last meeting and from 1.5% last October), but the board (9 members) unanimously maintained its inflation projection of 1.9% in the next fiscal year. If we have a quick look at the chart below, USDJPY is still trading within its tight 101.00 – 103.00 range. It found support slightly above the 101.00 level last week and seems on its way to test its next resistance at 101.94 (200-day SMA).

(Source: Reuters)

To finish, another currency AUDUSD that we have been trying to play lately is AUDUSD. The RBA minutes didn’t surprise the market on Tuesday despite AU policymakers’ willingness to see a lower Aussie (the minutes stated ‘the exchange rate remained high by historical standards’). We still think it is interesting to go short AUDUSD if the pair trades above 0.9400, with a medium term target at 0.9200 and a stop loss above 0.9560.

(Souce: Reuters)

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