Long ECB Short FRB
by Guy Haselmann, Director, Capital Markets Strategy, Scotiabank GBM
· New ECB actions were specifically intended to reap benefits through Euro currency devaluation. To achieve this aim, Draghi announced cuts in interest rates as well as administering Euro ‘printing’ through balance sheet expansion (€1,000bln or so). The ECB has had recent success as the EUR/USD dropped over 1.5% today and has fallen 5% since July.
· A weaker currency is desirable during periods of recessions and subdued inflation. Doing so, however, is not always seamless or the most ideal policy. Many global central banks, for instance, needed to follow the Fed’s lead in cutting rates after the 2008 crisis or risked having an undesirable appreciation of their home currency. Tensions can periodically arise, because two countries cannot become ‘more competitive’ at the same time (‘a race to the bottom’). Clearly, a weaker currency in one country means a stronger currency in another.
· There are times, however, when currency movements are mutually beneficial. Against the USD, Draghi is maximizing his efforts to weaken the Euro by trying to utilize ideal timing; expanding the ECB balance sheet at precisely the same time that the Fed’s is flat lining. The widening of interest rate differentials also helps. The FOMC likely welcomes today’s actions. Ideally, Draghi would have also wanted a Quid Quo Pro with Italy and France regarding economic reform; this sounds good in theory, but it is not how politics work.
· Despite Draghi’s vacant pleas for fiscal ‘arrows’, he had to ‘do his part’, particularly after backing himself into a corner after his Jackson Hole speech. Nonetheless, ECB actions surpassed expectations today. However, this probably means that the bazooka of sovereign QE is off the table for a while. On the other hand, since the ECB’s new forecasts for inflation and real growth are still too optimistic, Draghi might have positioned himself well to use that tool next year if absolutely necessary.
· Some believe that actions today were jointly agreed to by the Fed and ECB to allow the stimulus baton to be passed from one major central bank to another. Could this be to help ease the risk-off fallout that is likely to ensue in anticipation of the first Fed hike? Maybe the price action in US equity markets today should serve as an early warning signal.
· It is important to note that there are sharp contrasts between the US and Eurozone in terms of economic reality and needed fiscal reforms. These vast contrasts require different fixes and means that central actions to date have been dissimilar and will ultimately have varying results. Put another way, the ECB did not ‘take a page out of the Fed’s playbook’. Current and past actions of the ECB make much more sense than have those of the Fed.
· QE3 was always a questionable and debatable policy stance. For some, its continuation in recent months may have even veered toward irresponsibility. Economic data in the US has been steadily improving and some data is the best in almost a decade. It is not hard to argue that the Fed has been completely on the wrong track with its depression-like policy stance; a stance that has encouraged monstrous market speculation and moral hazard euphoria of epic proportions. It has likely resulted in a mammoth surge in obscured financial instability; the risks of which are not tempered in any way by the smoke-screen known as ‘monitoring’ and ‘macro-prudential’ policy.
· Moreover, the six years of Zero Interest Rate Policy (ZIRP), has ballooned debt levels; a good portion of which are buried on the Fed’s balance sheet. Shuffling debt chairs doesn’t fix underlying problems, but merely delays the inevitable. As Martin Wolf wrote in the FT, “beyond some point, the growth in debt adds to the fragility of the economy more than it adds to either personal welfare or aggregate demand. Amir Sufi argues this persuasively in his book House of Debt.” There is still failure in understanding the causes of past crises.
· Unlike at the Fed, today’s ECB actions must be worrying to the Swiss National Bank (SNB). The SNB’s 1.2000 floor for EUR/CHF stands diametrically opposed to the devaluation desires of the ECB. With little growth or inflation, the SNB would like to see the CHF weaken. However, there are factors putting upside pressure on the CHF (a safe-haven), including: an attractive interest rate differential to the EU; a 10% current account surplus; and heightened geo-political risks (particularly in Eastern Europe).
· How will the SNB manage its peg? It can no longer sell CHF for EUR and invest it in the negative yielding front end of Germany. This is a losing proposition. Will it have to drop the peg? Will it buy USD/CHF and invest the proceeds in Treasuries?
· Trades: Sell EUR/USD, EU Steepeners vs. TSY Flatteners, Short Bunds vs Long US10yr, Sell Junk Bonds and SPX, Buy 30yr TSY. Keep an eye on EUR/CHF. Contact to discuss.
“What happens if you get scared to death twice?” – Steven Wright
Global Macro Commentary September 4
Copyright © Scotiabank GBM
