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)

Euro and UK Updates

In short, inflation came in slightly above expectations at 0.4% YoY (vs. 0.3% expected), however it didn’t have much of an impact on the Euro. EUR/USD has been pretty rangy for the past couple of weeks, oscillating between 1.2875 and 1.3000. We see sellers at 1.2975-80, 1.3000 and 1.3025.

We believe that any bounce back above 1.3050 could be considered as a new opportunity to short the pair. Next target remains at 1.2800, greedy traders will target the 1.2750 retracement (9 July 2013).


(Source: Reuters)

We went short EUR/GBP at 0.8030 last week as we believe the pound will ‘recover’ slightly from its losses. Earlier this morning, the ONS figures showed that the number of people claiming Jobseeker’s Allowance in August fell by 37.2K (vs 30K expected), and the unemployment rate fell to 6.2% (vs 6.3% expected), its lowest level since October 2008. In addition, average earnings (ex bonus), the BoE’s new focus, edged up 0.1% to 0.7% in July and still stands much lower than the rate of inflation (CPI came in at 1.5% YoY in August).

The BoE minutes [of MPC Sep 3-4 meeting] showed once again that two policymakers – Ian McCafferty and Martin Wheale – voted to raise interest rates [by 0.25%] this month, leaving the central bank divided (7-2) for the second consecutive time. The implied rate of March15 Short Sterling futures contract (white line) is trading 8bps higher from last week’s low, bringing the value of the British pound with him (see Cable in green line).

On the top of that, the pound benefitted from 3 opinion polls suggesting that 52% of Scots will vote ‘No’ to independence…


(Source: Bloomberg)

Standard Bank on T-LTROs: The market expects the first TLTRO tomorrow to generate around EUR175bn of demand from euro zone banks.

Quick update on the Euro

This morning, EZ August flash inflation came in at 0.3% YoY and confirmed falling trend (from 0.4% in July). The ECB meets next week (September 4) and the market is pricing some action: talks of corridor rates cut, updates on the ABS program…

Our advice is ‘stay short EURUSD’ for those who got in already, or wait for a bounce back above the 1.3200 level for entering a short position. Large offers are seen at 1.3200 – 1.3250 (combined with huge expiries, 4bn Euros of vanilla option according to Reuters). Though the first support stands at 1.3100 where we might see a pause, our MT target remains at 1.3000. After German retail sales printed much lower than expected at -1.4% MoM in July (vs. 0.1% consensus), Italian quarterly unemployment rate rose to 12.6% in July (vs 12.3% expected) and preliminary inflation (EU Norm) entered into a negative territory, printing at -0.2% YoY and joining Greece, Spain and Portugal in recording annual consumer-price declines.

Peripheral yields picked up a bit, with the 10-year Italian and Spanish yields trading at 2.44% and 2.24% respectively, up from Wednesday’s low of 2.36% and 2.09%.

Our view goes for a corridor rate cut in order to optimize the T-LTROs (first starting on Sept 18). ABS purchases sound a bit premature…


(Source: Reuters)

Another way to play the Euro at the moment would be against GBP as we believe the market has overreacted to the some data disappointments and a slightly dovish QIR (Quarterly Inflation Report) back on August 13th. Good resistance level is at 0.7960/5, therefore going short EURGBP at around that level with a first target at 0.7880 (stop loss above 0.8020) could be a good strategy. Bank of England is also meeting next week but we expect it to be a non-event.