EURUSD versus ECB/Fed balance sheets

EURUSD vs ECB, Fed Total Assets

Market participants have been trying to explain the wondrous strength of the euro for many months now, but the single currency continues to hold its ground against the currencies of Europe's major trading partners despite the still struggling European periphery and increasingly disappointing economic data from the currency union's core countries.

Today's chart presents the EURUSD exchange rate on a weekly basis plotted against the balance sheets of the European Central Bank and the Federal Reserve. It suggests that central bank assets have played a key role in EURUSD movements since the beginning of the crisis in 2008. As can be seen, the USD tends to depreciate relative to the EUR when the Fed's balance sheet grows faster than that of the ECB and vice versa. In fact, the relative development of the two central banks' balance sheets has explained the EURUSD exchange rate almost perfectly.

What does this mean for the immediate future? If the above relationship  continues to hold, the EUR is unlikely to depreciate significantly versus the USD as long as the Fed's balance sheet is still growing or the ECB does not launch a QE programme of its own. The large EUR short positioning in the market is in favour of this scenario. However, watch those central bank assets, because their values will converge eventually and then EURUSD might finally drop out of its robust upwards trend ignited by Mario "Whatever it takes" Draghi in July 2012.

US dollar declines due to debt ceiling debacle

Expectedly, the US dollar softened on the final trading day of the week following an announcement by Treasury Secretary Jack Lew that the US government may run out of funds at some point in October if congress fails to close a deal on lifting the debt ceiling. A part of the American congress will be shut down on October 1, which is the latest date when a deal should be made in order to avoid excess volatility in the financial markets.

However, even if the US congress fails to lift the debt ceiling by then, crucial parts of it will continue work (it is only a partly shutdown), technically giving the country roughly two more weeks to find a solution. Investors should thus not buy into the fear-mongering in the financial press, even though caution is advised. Looking at the still relatively calm markets, especially compared to 2011 and the end of 2012, market participants seem to expect the US government to eventually come to an agreement before the deadline.

In addition to the budget talks, the increased uncertainty in the US stems from an ambiguous forward guidance policy of the Federal Reserve with respect to its tapering plans as well as an unfortunate search for a successor of Fed chairman Ben Bernanke.

The USD currently trades at $1.6134 against the GBP. The 0.6% gain of the British pound is not just due to the uncertainty in the United States but also because of an interview with Bank of England governor Mark Carney stating that there was little support for further quantitative easing (QE) in the UK. Cable is still about 1% below its rate from January 2013, but it has gained 6% over the past six months alone without any imminent signs of losing momentum.

The European common currency also appreciated relative to the dollar on a daily basis with EUR/USD currently trading at $1.3523. Looking at the performance over the last five trading days, this leaves the euro almost unchanged for the week. In the first half of the trading week, reports from Italy that members of the People of Freedom party were going to resign collectively if Silvio Berlusconi would be removed from the Senate caused the euro to decline. The losses have since been reversed against the dollar given the problems in the US. However, the situation in Italy still poses a serious problem, because the threat by Berlusconi's party members could well turn into a government crisis in the Southern European country. This is a risk for the European currency that may not be ignored, no matter how boring the troubles surrounding the "clown" Berlusconi may have become over the years.

Thoughts on OMT, QE3 and EURUSD

On Thursday, 6th September, ECB president Mario Draghi finally gave the financial markets what they had long been greedy for: The European Central Bank announced its so-called Outright Monetary Transactions (OMT) programme, which shall provide it with the necessary and theoretically unlimited firepower to ease the euro crisis.

As had been expected, the adoption of this programme has not been unanimous with Germany's Bundesbank strongly opposing the decision and pointing at the risks associated with it. In fact, Mr Draghi et al. committed the euro zone to a massive gamble. Unlike the central bank's previous programme, known as Securities Markets Programme (SMP), the OMT does not have any quantitative limit, as made clear by Mr Draghi (quote from press conference transcript):

First, in terms of the size, I said there is no ex ante quantitative limit to these interventions because we want this to be perceived as a fully effective backstop that removes tail risk from the euro area. But, at the same time, if we achieve our objectives, why should we continue making these interventions? If governments or countries do not comply, why should we continue doing so? These are the two conditions for exiting.

This basically means the ECB will continue buying sovereign bonds as long as it deems necessary. While this statement might have temporarily softened the pressure on the single currency, in the longer term it implies severe risks for the euro area as a whole, because Mario Draghi's statement alone will not be sufficient to blow investors' fears away for good. Eventually the central bank will have to come through on its promises and actually buy bonds of troubled economies for as long as the crisis persists. Not too long ago, in order to avoid a bank run, Mrs Merkel promised German citizens that their personal savings would be safe. Similarly, Mr Draghi promises Europe and, as a matter of fact, the world economy, that the ECB is both willing and able to control the euro crisis. The only feasible way of keeping that promise, however, will be to print more money. This willingness to relax the central bank's formerly strict stance on money creation is what Jens Weidmann, president of the Bundesbank, and Axel Weber, his predecessor, have been opposing. Unlike Mr Weber, Mr Weidmann does not seem frustrated enough to quit, yet.

From Germany's point of view, the OMT programme comes with a few downsides: If the ECB will create money for the purchase of struggling economies' bonds, inflation risk increases and the real value of German savings might decline.

Additionally, German exporters might not be hedged sufficiently against the sudden appreciation of the euro. Nobody had really expected a move as bold as Mr Draghi's. Quite the contrary: German companies had likely been expecting a lower euro at the end of the year.

Finally, the programme is meant to fuel economic growth in the euro zone - it does not follow the road of austerity Germany has been pushing for. The long-term risk is that Northern European countries continue to take on increasingly large amounts of debt and at the same time transfer part of their wealth to their Southern neighbours. This strategy cannot guarantee success. Take Greece as an example. Despite the many billions of euros that have been given to Greece already, economic recovery of any kind is still not in sight.

More than one year ago, I wrote in the comments section of a blog post that Greece should default in an orderly way. While this would be painful for the Greek population in the short term, it would allow the country to put its own monetary and fiscal policies in place and inflate its debt away. After all, has any country on the verge of bankruptcy successfully been saved in the past? Will there ever be enough money in the world to rescue an entire economy? I'll leave these questions open for now, but I remain sceptic.

Another risk embedded in the OMT programme is its strict conditionality. Governments going to apply for OMT funds must commit themselves to austerity plans as per the EFSF/ESM programmes. Quote from the 6th September ECB press release:

A necessary condition for Outright Monetary Transactions is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme. Such programmes can take the form of a full EFSF/ESM macroeconomic adjustment programme or a precautionary programme (Enhanced Conditions Credit Line), provided that they include the possibility of EFSF/ESM primary market purchases.

Countries like Spain and Italy should therefore be less inclined to actually seek help, unless they ultimately have to. Secondly, countries that do agree to new austerity measures might not profit from the ECB's bond buying as much as hoped, considering that spending cuts and tax raises might at least partly foil the positive effects of OMTs. I have no doubt that this strong form of conditionality was introduced in an attempt to oblige German interests.

How did all this move the EURUSD exchange rate? Last week's steep euro appreciation, which was initially triggered by the ECB's OMT announcement, was further supported by Germany's Federal Constitutional Court ruling that the ESM bailout fund was not in breach of the German constitution and then by the US Federal Reserve announcing a new round of quantitative easing ("QE3"), in effect pushing US bond yields down and thereby putting pressure on the US dollar as investors seek returns elsewhere. The US dollar index, which tracks the dollar performance against a basket of other major currencies, closed at a four-month low on Friday. Much like the ECB, the Fed did not set a quantitative limit to QE3. Instead, Fed chairman Ben Bernanke said the Federal Reserve would keep buying $40bn of mortgage-backed bonds per month not just until it sees a substantial improvement in the labour market, but for a considerable time after the first signs of a stronger economic recovery. In addition, the Fed will keep the federal funds rate at extremely low levels until 2015. Details from the 13 September press release:

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. (...)

The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. (...)

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.

Taking this into account, the euro might well continue to increase in value against the US dollar by the end of the week, although a lot of the USD devaluation and euro zone stimulus should be priced in by now. Looking at the daily EURUSD chart, the euro is in overbought territory already, but considering that volume has been increasing, I can easily see EURUSD ascending into the 1.325/1.33 range before a consolidation kicks in. This would be about the same level from which the euro starting falling in May 2012.

In the meantime, market participants will surely look out for more details on how the ECB is going to handle its OMTs and specifically the austerity conditions associated with the programme.

On a related note with regard to the controversial topic of fiscal austerity versus growth stimuli, I read a very interesting editorial by Paul Kirchhof in yesterday's politics section of German newspaper FAZ ("Der steinige Weg zurück"), arguing that the growth of government deficits in Europe has given capital markets increased power over European governments. Indeed, the collective of financiers has a great influence on the rates at which countries can finance themselves in the capital markets and on whether they can do it at all. While this should be a sign of a functioning market economy up to a point, the anonymity of today's capital markets, with dark pools and largely automated trading, might prove problematic in future. When it is difficult to clearly identify certain agents in the markets and their influence on prices, both government regulators and politicians will find it harder to do their jobs properly. In fact, they will be forced to constantly react to the actions of agents in the market instead of being able to oversee or control them.

Stock Markets Down on Fed Projections

Stock markets are down worldwide today after yesterday's Federal Open Market Committee (FOMC) June meeting and the release of its economic projections (PDF). The Federal Reserve projects unemployment in the U.S. to be high through the year 2013, when it should be 7 to 7.5 per cent, according to the Fed's latest estimates (this is up from last month's projections of 6.8 to 7.2 per cent). The wide range of projections even suggests the unemployment rate to be between 6.5 and 8.3 per cent (see image from the FOMC report below).

I think it's unsettling that unemployment is likely to remain that high until at least seven years after the start of the recession! Investors will be thinking the same, as suggested by international stock markets today. It certainly didn't help that Federal Reserve Chairman Ben Bernanke didn't hint at potential new steps to boost economic growth. Apparently, Mr Bernanke believes the current slowdown of economic growth to be temporary. Therefore, the central bank, which is ending its $600bn bond-buying program at this inauspicious time, will remain on hold for at least two more months before deciding about further interventions. Interestingly, the Dow Jones index temporarily jumped up yesterday right after a tweet by PIMCO's Bill Gross saying that August would likely bring first hints at QE3. However, as soon as the FOMC published its downgraded economic outlook for the US, markets turned down again.

Today's losses in Europe could also be due to profit taking after mostly good stock market performances on Tuesday. Charts below the fold. Continue reading "Stock Markets Down on Fed Projections"