Two years ago, the big worry in the global markets was the possibility that
Greece would opt to leave the Euro, which in turn, would set off a chain reaction,
in which Portugal, Ireland, Greece, Spain, and Italy might also choose to do
the same. The Euro's credibility was at risk as it plummeted towards US$1.200.
Nervous investors were thinking about withdrawing monies held on deposit with
European banks. A mini-flight of capital was already underway. Businesses and
households had withdrawn € 80-billion ($103-billion), from banks in Greece,
Ireland, Italy, Portugal, and Spain, during the first five months of 2012.
Earlier, in December '11 and February '12, the European Central Bank (ECB)
injected € 1.1-trillion of excess liquidity into the banking system, with
3-year loans, in order to create a buffer for Europe's biggest banks against
the threat of deposit flight. The ECB's actions helped to calm financial markets
for a few months, but the relief was short-lived. Doubts about the health of
Spain's banks and questions over Greece's future continued to linger.
Foreign investors were convinced that Greece, Ireland, and Portugal could
not survive their crushing debt loads . Their debt-to-GDP ratios were high
enough to make a default a serious possibility. Madrid had already asked for € 100-billion
in rescue loans to prop-up Spanish banks . Spooked about the possibility of
a break-up of the Euro, foreign investors had already dumped €242-billion
worth of Italian bonds, lowering their exposure to 35% of bonds outstanding
in May '12, compared with 51% a year earlier. Foreign investors also slashed
their exposure to 26% of Spain's bonds, from 40% a year earlier.
Belatedly, the rating agencies weighed in with their opinions. S&P cut
Spain's sovereign credit rating to BBB-minus, or 1-notch above junk territory,
citing a deepening economic recession. Moody's also issued a Baa3 rating, and
put Spain on review for a possible downgrade. S&P lowered its long-term
sovereign credit ratings for Italy to BBB from BBB+, or two notches above junk
status, citing the size of Italy's public debt which is today is 132% of gross
domestic product, the second highest in the G-20 world, behind Japan.
However, the banks in Italy and Spain took a contrary position, and were acting
as lenders of last resort for their governments, and ended up as the biggest
winners from the crisis. Spanish banks borrowed more than €300-billion
from the ECB, and plowed much of the money into Spanish government bonds. Likewise,
Italian banks borrowed €255-billion in ECB loans, between late 2011 and
early 2012, and used it to buy sovereign bonds. As a result, Italian banks
controlled 57% of Italy's marketable debts, and Spanish banks owned 67% of
Spain's marketable debt by the summer of 2012. Without the ECB's "backdoor
QE" scheme, borrowing costs for Italy and Spain could've spiraled sharply higher,
like in Greece, and increased the odds of a default - on the very bonds held
by the banks.
As such, the Spanish government and Spanish banks became perilously co-dependent,
in what was called a " doom loop," in which frail banks and troubled debtors
states recycle the same money to prop each other up. However, the difference
between the return offered on the sovereign bonds and the low cost of borrowing
from the ECB generated enormous net interest income and spectacular capital
gains for the Italian and Spanish banks. In Kaiserstrasse, the Frankfurt home
of the ECB, Mr Draghi delivered a clear message, "If we are to do an operation
similar to the LTRO, we're going to make sure this is being used for the economy.
And we'll make sure this operation is not going to be used for these "carry-trade" operations."
A Greek exit from the Euro currency could've opened-up a "Pandora's box," and
left the door wide open to other disasters. Europe's biggest banks were still
sitting on $1.2-trillion worth of debt issued by Spain, Portugal, Italy, and
Ireland, and nursing huge losses, and with t raders piling up bets on the break-up
of the 17-country Euro currency bloc, the situation looked grim. On May 9th
2012, the Euro Stoxx Banks index, a basket of 30-Euro-region banking stocks
tumbled below the depths of March of 2009, "Great Recession" lows. The Markit
iTraxx Financial Index of credit-default swaps on the senior debt of 25 European
banks and insurers reached 308-bps, matching the highest since the days before
the ECB's first offering of 3-year repos. The Euro fell to a 21-month low against
the US-dollar.
However, on July 26th, 2012, with 23 ad-libbed words, ECB chief Mario Draghi
changed the course of the Euro-zone debt crisis. "Within our mandate, the ECB
is ready to do whatever it takes to preserve the Euro. And believe me, it will
be enough," he warned. It was a master stroke. Draghi never needed to back
up his tough words with action. Draghi's "Jawboning" proved to be a game changer,
- it took the systemic risk out of the Euro-zone's financial markets with the
ECB implicitly guaranteeing the bonds of the troubled debtors in the Euro-area,
and thus, reducing the likelihood of a break-up of the Euro.
Today, the ECB can look back and rightly claim to have staved off a financial
disaster. The ECB's pledge made on Sept 6th, 2012, to throw its unlimited financial
clout behind an effort to protect Spain and Italy from financial collapse by
pledging to buy their bonds on the secondary market, was enough to ultimately
drive Italy's and Spain's 10-year bond yields dramatically lower. Since then,
Italy's 10-year borrowing cost has dropped a stunning -325-basis points (bps)
lower and Spain's tumbled -450-basis points lower, from their peak crisis levels.
The nightmare scenario was averted. Subsequently, sharp declines in Greek,
Irish, Italian, Spanish, and Portugese bond yields, fueled a huge +60% increase
in the market value of the Euro-Stoxx index fund, (NYSE ticker; EZU), to above
$42.50 /share in New York. On April 10th, 2014, the ruling politicians in Athens
celebrated the return of Greece to the global bond markets. Crazed investors
placed €20-billion worth of bids to buy €3-billion of 5-year Greek
notes, even though Moody's rates Greece's at nine notches below investment
grade at Caa3 , and S&P and Fitch rank Greece's debts at B-. Still, buyers
accepted an interest rate of 4.75% on the 5-year note issue. The ultra- low
interest rate signals a supreme level of confidence among investors that the
ECB would act to backstop the bonds, if necessary.
Currency carry traders decided to hop on the bandwagon, by borrowing monies
in Japanese yen and US-dollars, and plowed the cheap cash into high yielding
Euro-zone bonds. Carry traders bid-up the value of the Euro's exchange rate
to above ¥140, from less than ¥100. The Euro rebounded +16% against
the US$ to as high as $1.3950. These leveraged bets helped to depress the yields
on Italian and Spanish bonds to within spitting distance of yields offered
by British Gilts and US Treasury notes.
Also bolstering the Euro's advance is a tightening of liquidity conditions
in the Euro-zone's banking network. Over the past two years, banks have repaid
more than €700-billion of the ECB's 3-year repo loans (LTRO's). Excess
liquidity, - the amount of money beyond what banks need for their day-to-day
operations - fell to €86-billion this week, the lowest since late 2011.
Excess liquidity peaked at €804-billion in early 2012 . As a result, the
Euro is buoyant, and bumping up against the psychological US$1.40 level and
hovering above ¥140.
The problem for the Euro-zone however, is that one monetary policy doesn't
impact all the members the same way. When it comes to exports, each individual
country has its own threshold of pain, when a too strong Euro begins to undermine
the competitiveness of their top exporters in world markets. For instance,
Germany's threshold is estimated at $1.370.
In the case of France, exports begin to stagnate when the Euro /US$ exchange
rate exceeds $1.24. And exports account for 25% of France's economic output.
This key engine of economic growth has been stagnant for the past 14-months.
In Feb '14, French exports totaled €3.62-billion or only +1% higher than
a year earlier. For Italy, the threshold of pain for its exporters is estimated
at $1.170. Italy's export growth has been stagnant for 18-months. At €31.8-billion
in February, Italy's exports were +3% higher than a year earlier.
The Euro's trade weighted index against a basket of its top trading partners
is hovering at the 111.5-level, around its mid-point for the past six years.
Still, French political leaders are worried that further gains for the Euro
can make matters much worse. On April 29th, France's Prime Minister Manuel
Valls addressed the parliament, and took aim at the strong Euro. "The EU has
to introduce measures to promote economic growth, ranging from encouragement
of major investments to labor policy. But also a more appropriate monetary
policy, because the level of the Euro is currently too high," Valls declared.
French President François Hollande has struggled to breathe new life
into the Euro-zone's second-biggest economy and to keep his oft-repeated promise
to get unemployment falling. The French unemployment jumped +0.9% in February,
with roughly 3.35-million out of work, which is +4.7% higher than a year earlier.
Some 177,800-workers joined the jobless register in 2013, after 283,800 were
added in 2012. According to a recent poll conducted by France's Opinion-Way,
some 82% of the French are not satisfied with the government's handling of
the economic and social issues, and Hollande's failure to tame the jobless
rate has driven his approval ratings to record lows for a president in modern
France.
The European Commission said that with weak growth, employers are likely to
favor increasing productivity instead of job creation in France. It forecasts
the unemployment rate will remain stuck at a 17-year high of 11% through 2014
and 2015. The French government forecasts its economy will grow by an anemic
+1% this year after posting very slight growth in 2013. A quarter of against
its trading partners' currencies since July '12.
Mr Draghi, who famously declared in July '12, that the ECB would do "whatever
it takes to save the Euro," is now making a 180-degree U-turn, saying at a
Jan 9th news conference that that the Euro has become too strong, and a further
appreciation could threaten the Euro-zone's tepid recovery. While the ECB does
not profess to have a target level for the Euro, there's been a steady drumbeat
of comments, issued by most ECB members, since the Euro first cleared the $1.370-level,
and the rhetoric escalated as the Euro approached $1.400.
On April 12th, Draghi himself threw down the gauntlet, saying that Euro's
exchange rate is important first and foremost for price stability, because
when we say price stability, we mean price stability in both directions. So
whenever we are distant from a +2% inflation rate we are in a situation of
having a problem of reaching price stability. The Euro's exchange rate is an
important dimension for us," he said.
The Euro's increasing strength has also undermined the ECB's attempts to stabilize
the rate of inflation - which slowed to +0.7% in March, and well below its
target of +2%. It was the seventh straight month that inflation remained below
the "danger zone" of +1%. The ECB figures the Euro's 21-month rally has shaved
-0.5% off the region's inflation rate . While the phenomena of "Low-flation," is
not as damaging as deflation, (a broad-based decline in prices), it still threatens
the same perils of delaying consumer spending, undercutting corporate revenue,
and often leads to companies stop creating jobs.
"We know that the longer the inflation rate stays below +1%, the higher will
be the risk that it will not go back to +2% in any reasonable time - in other
words, inflation expectations could actually be dis-anchored, and we don't
want that." Therefore, "a further strengthening of the Euro's exchange rate
would require further monetary stimulus," Draghi warned on April 12th. ECB
member Benoit Coeure chimed in on April 11th, "The level of the Euro is important
in our monetary policy making. Why? Because it impacts the inflation rate and
we have an inflation mandate. The stronger the Euro, the more need for monetary
accommodation."
Mr. Draghi has argued, though, that low inflation is largely the result of
falling energy prices and other one-time factors and the inflation rate will
pick up in May, without the need of the ECB's intervention in the marketplace.
He might be right. For most of the second half of 2013, the Continuous Commodity
Index, a basket of 17-equally weighted commodities, was submerged -15% lower
on a year-over-year basis, against the Euro. Given the time lag between the
advanced movements of commodity prices, and the subsequent reporting of official
government statistics on inflation, today's sub +1% inflation rate is not surprising.
However, the Continuous Commodity Index has recently surged +10% higher, and
finds itself unchanged compared with a year ago, - and unwinding deflationary
pressures.
The ECB says it will "wait and see" awhile longer, to see if how EuroStat's
numbers on inflation play out in the weeks ahead. Until, then, the ECB is relying
on "Jawboning," or verbal threats, in an attempt to discourage traders from
bidding up the Euro above the psychological $1.400-level. That's where the
ECB has drawn its red-line in the sand, yet the Euro is less than 1% away from
the key resistance area. Perhaps, many traders believe the ECB is bluffing
on its threats to block the Euro's advance, with a more radical monetary policy,
such as QE, and are trying to probe and test the ECB's resolve, with a few
quick stabs at $1.400, in order to see if the forays trigger a forceful response
from the central bank.
Since November '13, ECB officials have been saying they would invent new policies,
if necessary, in order to insure the Euro zone does not fall into the deflation
trap. Six months later, the marketplace is still hearing the same message.
On April 14th, Bank of France chief Christian Noyer warned " we will use every
instrument within our mandate, including unconventional ones, in order to cope
effectively with risks of a too prolonged period of low inflation ." However,
the ECB doesn't have to invent a new scheme to enforce a ceiling for the Euro's
exchange rate, it can simply follow the blueprints of the Swiss National Bank
(SNB), which has enforced a floor for the Euro against the Swiss franc for
the past 2-½ years.
The SNB put a floor under the Euro at 1.20 Swiss francs in Sept '11 in order
to help stave off a recession and the threat of deflation. It had to intervene
heavily in mid-2012, to maintain the floor, purchasing $205-billion worth of
Euros, as the Euro zone crisis flared. "The European crisis may have become
somewhat less virulent, but it has not been overcome, SNB chief Thomas Jordan
warned on April 25th. " With Swiss interest rates close to zero and a high
Swiss franc, the minimum exchange rate is still the key monetary policy instrument
for the SNB."
Jordan said the SNB is ready to enforce the policy by purchasing foreign currency
in unlimited quantities and would take other measures if necessary. That verbal
threat has been sufficient enough to keep currency traders at bay for the past
year. Jordan said it was hard to predict the impact of the ECB launching QE
in the Euro-zone, on neighboring Switzerland, but the SNB is determined to
continue battling currency traders. The SNB is a veteran of battles with falling
consumer prices, navigating through two years of negative inflation and a currency
shock in the summer of 2011 that briefly knocked the Euro to parity with the
franc.
Bundesbank chief Jens Weidmann, - the council's arch hawk, has tossed aside "moral
hazard," and says charging negative rates on bank deposits held at the ECB
should be the first line of defense against a too strong Euro exchange rate.
Weidmann says he's open to suspending the sterilization of the ECB's previous
bond purchases. "If we're discussing how to inject liquidity into the market,
instead of creating a new instrument, the most straight-forward manner would
certainly be to either pause the absorption operation or reduce them in size." Ending
the sterilization would add about €175-billion into the financial system.
After digging in his heels as a matter of principle, Weidman even gave his
qualified support for launching QE, as the last option, to prevent "low inflation" from
becoming entrenched.
On April 4th, a report in the Frankfurter Allgemeine Zeitung said the QE-option
of purchasing bonds would need to be of a massive scale in order to impact
consumer prices in the 18-member currency bloc. The newspaper said one ECB
model showed €1-trillion of bond purchases spread over a year would boost
inflation by +0.2%, while another model pointed to a +0.8% uplift. "If we are
talking about generalized asset purchases, it will have to be about asset purchases
in all countries," ECB deputy, Vitor Constancio said. It's widely expected
that the ECB would begin to unveil a liquidity injection scheme in the month
of June, as it seeks to enforce a ceiling for the Euro at $1.400 vs the US
and 144-yen.
This article is just the Tip of the Iceberg of what's available in
the Global Money Trends newsletter. Subscribe to the Global Money
Trends newsletter, for insightful analysis and future predictions about
the (1) top stock markets around the world, (2) Commodities such as crude oil,
Gold, copper and base metals, (3) Foreign currencies, such as the Australian
and Canadian dollars, Brazil real, the Euro and Japanese yen, (4) Central bank
interest rates and global bond markets, (5) Central bank Intervention techniques
(6) and key Credit Default Swap markets.
GMT filters important news and information into (1) bullet-point, easy to
understand reports, (2) featuring "Inter-Market Technical Analysis," with
lots of charts displaying the dynamic inter-relationships between foreign currencies,
commodities, interest rates, and the stock markets from a dozen key countries
around the world, (3) charts of key economic statistics of foreign countries
that move markets.
Subscribers can also listen to bi-weekly Audio Broadcasts, posted Monday
and Wednesday evenings, with the latest news and analysis on global markets.
To order a subscription to Global Money Trends, click on the hyperlink
below,
http://www.sirchartsalot.com/newsletters.php
or call toll free to order, Sunday thru Thursday, 8-am to 9-pm EST,
and on Friday 8-am to 5-pm, at 888-808-7978. Outside the US call 561-391-8008.
