The Forces at Work as Developed World Currencies Diverge

As Europe still manages fallout from the SNB breaking the Swiss Franc peg earlier this month, we can discuss emerging market countries that might feel similar pressure from Europe and the US soon. It is easy to forget the extent to which emerging market economies rely on other currencies:

Source: Currency Substitution / Wikipedia

Of all major base currencies, the euro and US dollar have displayed the largest divergence in recent months as the US economy strengthens and the EU continues QE.

Source: @RoutersJamie

The SNB’s action earlier this month is an interesting case study on countries pegged to a depreciating base currency. The SNB’s move was unexpected largely because the relative weakness of the Swiss franc looks positive for Switzerland at first glance. As an exporting nation, Switzerland benefits greatly from a weaker currency and greater trade competitiveness.

Source: Trading Economics

The usual concern about devalued currency is inflation, though this was clearly not an issue for the Swiss.

Source: Trading Economics

Instead, the SNB was concerned with the mounting foreign exchange reserves necessary to maintain their peg. The EU’s latest expected round of QE, along with CHF’s ongoing use as a safe-haven currency, forced the SNB to reach $500 Billion in foreign reserves.

Source: Trading Economics

Such large European exposure and expected future easing outweighed the benefit of favorable terms of trade and lower risk of deflation that came from weaker currency. 

Turning to other Euro-pegged countries, we see a similar trend in foreign exchange reserves.

Source: Trading Economics

Source: Trading Economics

Source: Trading Economics

In contrast, the US dollar has appreciated on recent strong economic news, and USD-pegged countries should be drawing down on foreign currency reserves to strengthen their domestic currency. Though recent evidence is weak, we may see further draw-downs soon:

Source: Trading Economics

Source: Trading Economics

Unlike euro-pegged currencies, stress on US dollar pegs will be far more direct: countries will draw down on foreign exchange reserves as the first line of defense. This will generally result in tighter monetary policy at a time these nations struggle with slower global growth. Once they can no longer buy domestic currency in open markets, they may turn to grimmer deflationary measures such as seizing currency through higher taxes. For now, we’ll have to watch out for USD-peg rumblings (GCC) and avoid speculation (Hong Kong).
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Greece's fight against "fiscal waterboarding" will halt economic recovery

We are about to witness a historic showdown between the major euro area institutions and Greece. Greece's newly appointed finance minister Yanis Varoufakis, a staunch bailout critic, will lead the negotiations on debt haircuts. On the other side will be the creditors: the International Monetary Fund and the European Commission - with additional support from the ECB. Private bondholders may get dragged into the fight as well (although many of them are Greek banks who will do what the government tells them). A number of Eurozone politicians have already expressed skepticism about any debt forgiveness for Greece. But Varoufakis is likely to focus on the argument that Germany has to take a great deal of the blame for the situation in which Greece now finds itself - calling the imposed austerity measures "fiscal waterboarding". Here is a good quote from Strafor:

Stratfor (via Forbes): Another version, hardly heard in the early days [of the Eurozone crisis] but far more credible today, is that the crisis is the result of Germany’s irresponsibility. Germany, the fourth-largest economy in the world, exports the equivalent of about 50 percent of its gross domestic product because German consumers cannot support its oversized industrial output. The result is that Germany survives on an export surge. For Germany, the European Union — with its free-trade zone, the euro and regulations in Brussels — is a means for maintaining exports. The loans German banks made to countries such as Greece after 2009 were designed to maintain demand for its exports. The Germans knew the debts could not be repaid, but they wanted to kick the can down the road and avoid dealing with the fact that their export addiction could not be maintained.

The debate will also focus on the fact that Greece has done an amazing job in cutting its debt/GDP ratio - in spite of the falling GDP.

Source: @RBS_Economics 

Greek government bond yields spiked on Syriza's escalating rhetoric as well as on the right-wing anti-austerity party (Independent Greeks) becoming Syriza's new coalition partner. Think about it - the only thing the two parties have in common is their hatred for the Eurozone and the fiscal pain that was imposed on Greece.

The Greek government bond yield curve has become more inverted as markets price in principal reductions that are likely to apply evenly across the curve (which is what typically causes such inversion).

It is expected that if such haircuts are applied, they would hit both official and unofficial accounts (including bonds held by the ECB). Debt forgiveness would also cut principal on the government bonds held by Greek banks - who are some of the largest holders. That's why shares of Greek banks got decimated today. New bank bailouts will be required if there is any hope for credit availability to the private sector. For now most credit activity will come to a grinding halt - and with it any hopes for economic recovery.

Source: @WSJGraphics

The overall equity market fell over 9% today as government officials halt privatization and extend an olive branch to Russia (see story).

The newly elected government may ultimately get its debt forgiveness. But in the process the damage done to the nation's private sector will be severe - just as Greece begins to come out of a deep depression that rivals some of the worst downturns in global history.

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Canadian Banks Hesitate to Follow the Bank of Canada's Rate Cut

The Bank of Canada surprised markets last week when they lowered the overnight rate 0.75% on Wednesday. The bank cited low oil prices, which have rendered much of Canada's oil production unprofitable and resulted in downward pressure on growth and inflation expectations.

Source: National Post

Source: Bank of Canada

As we discussed last month, this relief was much needed to reverse these trends and support Canada’s faltering housing market.

Source: The Canadian Real Estate Association

Some are raising concerns that the Bank of Canada focused too narrowly on oil production by ignoring recent growth in manufacturing, stable employment, and potential adverse effects of increased lending amid high household debt levels.

Source: Bank of Canada

Source: Trading Economics

Source: FRED

Canada’s "Big Five" banks seemed to agree and did not lower prime lending rates following Wednesday's announcement.

Financial Post: Toronto-Dominion Bank, Canada’s largest lender, says it has no plans to cut its prime rate to match the central bank’s move, keeping the rate linked to variable mortgages, car loans and other securities, at 3%. Other banks, including Royal Bank of Canada, are also holding off.
“Our decision not to change our prime rate at this time was carefully considered and is based on a number of factors, with the Bank of Canada’s overnight rate only being one of them,” spokesman Mohammed Nakhooda said in an e-mail statement. 

Their decision undermines the Bank of Canada's main transmission mechanism by not providing lower rates to consumers and businesses. Federal Finance Minister, Joe Oliver, says the Bank of Canada won’t intervene, so we will just have to wait and see if the Big Five come around to lowering rates themselves. In the meantime, Wednesday's announcement further weakened the Canadian Dollar, which will boost exports.

Source: Bank of Canada

Source: Bank of Canada

The Big Five's decision may be all the better for Canada: exporters benefit from a weaker Canadian Dollar, while inaction in bank prime rates prevents potential overheating in real estate and credit markets.

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Markets pricing in substantial QE operation by the ECB

Evidence continues to mount of the ECB's impending quantitative easing announcement. Here are some indicators:

1. The European Court of Justice in effect cleared the way for such a program (see story). Furthermore, there are options on the table that may avert major hurdles for Germany (see post).

2. The SNB's action last week suggests that the central bank is preparing for new inflows of euros it can no longer stomach.

Deutsche Bank: - ... the timing of the SNB’s decision suggests that they do expect the ECB to deliver next week.

3. The Eurosystem consolidated balance sheet (chart below) is expected to begin declining again, as the area's bank deleveraging results in repayments of loans to the ECB. The TLTRO program and the current securities buying activity (ABS, covered bonds) remain insufficient.

Source: ECB

4. The CPI is in the red (see chart) and there is no improvement in the swaps-implied inflation expectations. This is something that Mario Draghi and team watch quite closely.

Orange = swaps-based euro 5yr forward 5yr inflation expectations. Purple = the same for the US

Source: @Schuldensuehner

5. Short-term rates in the Eurozone are moving deeper into negative territory. The German 3-year government yield is now at negative 15bp (see chart). The overnight interbank rate (EONIA) is also falling.

Source: ECB

In fact the term structure of the overnight rate expectations has shifted sharply lower - with negative overnight rate expected to persist well through the end of 2016.

Source: Deutsche Bank

The market expects the banking system to be flooded with liquidity generated by quantitative easing for a long time. The area's banks will therefore prefer lending to each other at negative 8-12 basis points to depositing with the ECB at negative 20 basis points - as they play "hot potato" with new infusions of liquidity.

With this in the background however, it's important to point out that the ECB has been known to disappoint. Many of the Eurozone periphery bond yields are at or near record lows anticipating this action from the ECB (priced to "perfection"). The euro is at multi-year lows (see chart) - also expecting the ECB to act. A substantial QE program is now priced in. Anything but a "bazooka" announcement will send shivers through the markets, resulting in a volatility spike. The bet is on that the ECB will come through with "shock and awe".

10-yr Italian government bond yield had a record low close last week

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Tough times ahead for the Swiss economy

The Swiss National Bank’s unexpected abandonment of the Swiss franc cap continues to reverberate across global markets (examples listed below). The currency settled around parity, which is about 17% above the cap (the euro is 17% lower). At this level the SNB loss on its massive foreign currency position (mostly euro) is somewhere around CHF 75 bn.

Note: The chart shows the EUR falling against CHF (CHF rising 17% above the cap level)

The buildup of euros was the result of having to defend the franc cap when capital was flowing out of the Eurozone into Switzerland (the SNB had to buy euros and sell francs). The central bank came under enormous criticism domestically for becoming so exposed to the Eurozone. But now the central bank is cutting its losses and walking away from having to buy any more euros.

In the past few years, the currency cap resulted in (relatively) easy monetary policy by keeping the franc artificially weak while the SNB balance sheet expanded via the euro purchases. While the mechanism was different than what we had with other central banks who have undertaken quantitative easing, the SNB's balance sheet had ballooned in recent years (see chart).  As a result, the nation’s stock market had outperformed other European markets by some 30% since the cap was instituted. When it comes to pumping up the stock market, easy monetary policy clearly works.

Source: @acemaxx  

But once the valve was opened and the Swiss franc was allowed to appreciate, the Swiss stock market gave up some 15% in just two days (chart below). In effect the SNB ended its version of “quantitative easing” in a few seconds rather than by “tapering” as was the case in the US.

Source: Investing.com

With this decision the SNB has lost a great deal of credibility - not due to the change in policy but due to its execution. The central bank looks divided, uncertain, and subject to political pressures.

Switzerland was already entering deflation before the currency was allowed to appreciate. Now the nation is about to undergo what Japan had a few years back. During the Eurozone crisis, the yen which - just as the Swiss franc - was a "safe haven" currency, strengthened significantly, nudging Japan into deflation. The situation in Switzerland is now similar, except that rather than easing policy further as the BOJ did, the SNB tightened it. For the Swiss economy difficult times lie ahead.

Examples of the fallout from the SNB's sudden policy reversal:

1. FXCM
2. Alpari UK
3. Everest Capital

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The ECB exploring QE options

The ECB is currently in the process of designing a fresh €500bn securities purchase program. There are multiple options on the table and the central bank is having staff run through a number of scenarios. Asset classes and asset quality scenarios run the gamut - from AAA assets only to everything from BBB- and up. The possibilities include government bonds only as well as a mix that also contains private credit. This is all in addition to the ABS and covered bond buying programs already in place.

But here comes the tough part - risk sharing. The ECB is looking at three possibilities:

Method-1. The full amount of securities purchased is shared based on each member-state ownership of the ECB (capital subscriptions). This is how risk has been shared so far on purchases by the central bank. It would be similar to the so-called Securities Market Program (SMP), which is how the ECB originally got stuck with defaulted Greek debt. Of course the Germans, with their 26% exposure to the ECB, are quite unhappy about this.

Method-2. Another option on the table is to run bond purchases similarly to the so-called emergency liquidity assistance (ELA). In such a program "any costs of, and the risks arising from, the provision of ELA are incurred by the relevant NCB" (NCB stands for National Central Bank, such as the Bank of Italy for example). In such structure, each NCB would buy some prescribed amount of its nation's government bonds and assume all the risk of these purchases. Thus the Bank of Italy, not the ECB, would assume all the risk for Italian government bonds it purchases via this program.

While this option would appease Germany, such action would edge closer to a decentralized Eurozone, risking the disintegration of the monetary union. At the same time it also doesn't completely segregate the risk because many periphery NCBs owe the Eurosystem money via TARGET2. That means if one of the NCBs becomes insolvent due to an over-concentrated exposure to its national bonds, it could still be damaging to the ECB's stakeholders.

Method-3. The third option would apply Method-1 of risk sharing (above) up to some amount of purchases (let's say the first €250bn), after which the ECB reverts to Method-2 (above) for the remaining purchases.

At this point it's all about picking the "lesser evil". Any large government bond purchase program in the euro area creates a moral hazard, removing the incentives for fiscal discipline. With interest rates at historical lows driven by central bank purchases, politicians are likely to institute new spending programs - such as the ones that brought about the Eurozone crisis.

Nevertheless the ECB has little choice at this point as deflation knocks at the door. The area's CPI is now in the red (and France is expected to be there shortly), while longer dated inflation expectations are collapsing.

5y5y forward inflation swap rate (source: @Schuldensuehner)

Furthermore, the programs deployed thus far, such as TLTRO, have been simply inadequate to address these rising deflationary pressures. One way or another, quantitative easing in the Eurozone is now inevitable.

Consolidated Eurosystem balance sheet (source: ECB)

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Rising deflationary risks in the United States

Unlike a number of other nations - especially some countries in Europe - the US is currently not dealing with general price declines. However, the risks of such an occurrence have increased materially. This for example can be seen in the intermediate-term market-based inflation expectations, which have fallen to 2009 levels - when deflation was a serious concern.

One key data point supporting these rising risks came from last Friday’s jobs report. The report showed wage growth falling from a fairly stable level of 2% per annum.

In particular, “production and nonsupervisory employees” saw a sharp decline in wage growth - in spite of robust growth in payrolls (see chart).

Economists have been expecting the recent strength in US labor markets, including big increases in job openings (see chart), to translate into stronger wages. However, just the opposite has taken place.

Now, combine slowing wage growth with global disinflationary pressures and the collapse in energy as well as other commodity prices (see copper price for example). Below is the CRB commodity index.

Plus, as an additional data point, the PriceStats CPI trend (online-price-based CPI-tracking model) has fallen to 2009 levels.

Blue = actual CPI, orange = PriceStats index (h/t @jp_koning)

Putting it all together points to rising risks of deflation in the US. There is absolutely no way the Fed can raise rates in this environment. In fact some Fed officials are quite open about taking any 2015 rate hikes off the table.

Nevertheless, the markets still anticipate the first hike in late Q3/early Q4 of this year. This is somewhat surprising, considering that in the UK, for example, rate hike expectations have been shifted to 2016 (see chart).

It's not that a 25-50bp Fed Funds rate hike by itself will have much of an impact on the US economy. In fact short-term rates actually rose at the end of last year without most people even noticing (see post). Raising short-term rates in the US (while the rest of the world is on hold or lowering rates) risks pushing the dollar higher. And a much stronger dollar would exacerbate some of the trends discussed above, increasing the possibility of deflation in the US.

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Energy price declines not limited to oil

With all the focus on falling crude oil prices (chart below) as well as sharp reductions in the cost of gasoline (including retail), jet fuel, and heating oil, it's easy to miss the fact that prices of other energy products have been hit quite hard as well

Source: barchart

Here are a few examples:

1. US natural gas price declines have been spectacular.

March 2015 futures contract (source: barchart)

Natural gas valuations are of course responding to the correction in oil. But other factors include strong US gas production and the normalization of gas inventories in storage after the harsh 2013-14 winter.

2. Coal prices have fallen sharply as well, particularly for Appalachian coal (see chart). Coal traded in Asia (chart below) has also been under pressure.

Source: barchart

3. Price declines have not been limited to fossil fuels. Even uranium futures have been selling off in spite of rising Japanese demand, as nuclear reactors go back online - see chart.

4. Expectations of weakening profitability for alternative energy sources, including wind and solar, are showing up in the significant share underperformance against the broader markets (which started with declines in crude prices).

          Red = solar shares; Blue = S&P500

           Red = wind energy shares, Blue = S&P500

Source: StockCharts.com

5. With major sources for power generation becoming cheaper, electricity prices (chart below) have declined as well.

January-2015 PJM Monthly On Peak (source: barchart)

As discussed before (see post), this is quite positive for the US (and global) economy. However a number of industries involved with products discussed above will be severely disrupted in 2015, resulting in debt restructuring, consolidation and some job losses.

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