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This is the third post in a series of four on recent economic, financial, and political developments in the Euro-zone rooted in the sovereign debt crisis. This third post will continue the examination of the economic challenges resulting from the crisis and how regional policymakers intend on addressing them.

Keeping in mind the chart from the first post in this series, the chart below gives prescient insight into how the ECB’s future policy actions will drive the Euro. We know this to be the case because market participants have already exhausted their enthusiasm towards peripheral European debt, and if yields creep back up as the economics remain a lingering problem, there is only one option for the ECB: expand its balance sheet.

ECB Balance Sheet

The above chart shows the ECB’s total balance sheet assets (€B) (white) plotted against the EURUSD (yellow – inverted Y-axis). The relationship expressed suggests that the greater the size of the ECB’s balance sheet, the weaker the Euro is versus the U.S. Dollar. We actually can even take away the point that as the ECB’s balance sheet contracted significantly (approximately €500B) between late-December and late-April, the EURUSD only rallied slightly. However, as the ECB’s balance sheet expanded dramatically in late-2011 through mid-2012, the EURUSD fell in line.

Accordingly, with yields suppressed in the near-term, we suggest that any further action the ECB takes will necessarily result in the reexpansion of its balance sheet, which will weaken the Euro in the short-term, despite the implication of longer-term benefits (market participants will need to see it to believe it before they can buy into a stronger Euro). In recent weeks, as significant PMI survey reports fell below consensus forecasts and evidence of increased erosion in Italian, Greek, and Spanish labor markets was released, chatter has arisen the ECB is exploring the idea of implementing a program similar to the Federal Reserve’s TALF, or Troubled Asset Relief Program, in 2008.

The TALF absorbed $200B of bad loans from American banks beginning in late-2008, thereby allowing them to unfreeze credit and resume lending to individuals and smaller enterprises. The ECB hopes to replicate the results with a potential SME lending program, or a facility for small- and medium-sized enterprises to restore credit flow to the Euro-zone economy. The program could take the shape of outright loans, which would likely have an admittedly smaller impact on the Euro and even could be positive. But what’s more likely is that the ECB utilizes the tried and true model of the Fed, opens its balance sheet and absorbs bad debt, and lets the Euro’s exchange rate suffer.

This may not be bad. According to data manipulated by Barclay’s Capital, a -10% decline in the EURUSD exchange rate would help boost Euro-zone exporters’ competitive edge, leading to a +0.75% to +0.80% boost in GDP. Long-term, when the Euro-zone economy recovers, so too will the Euro. But in the near-term, any depreciation that takes place will be at the hand of a very willing ECB – President Draghi said last week that the central bank stands “ready to act” – an ECB that will sacrifice its balance sheet for the sake of restoring credit flow to the Euro-zone. Continued downside pressure on the Euro into the 3Q’13 is likely as a result.

The final article in this series will examine the political aspect of the crisis and the upcoming calendar of Euro-zone-specific events that all market participants, both speculators and bonafide hedgers alike, will need to be aware of over the coming months.

This is the second post in a series of four on recent economic, financial, and political developments in the Euro-zone rooted in the sovereign debt crisis. This second post will examine the economic challenges resulting from the crisis and how regional policymakers intend on addressing them.

With borrowing costs in the periphery of the Euro-zone at multiyear lows, and in some cases, all-time lows, it’s difficult to say that the financial aspect of the European sovereign debt crisis is still an issue. The previous post in the series illustrated how the plunge in short-term Italian and Spanish government bond yields has helped keep the Euro afloat. Certainly, the relieved pressure didn’t materialize by its own doing; instead, that credit can be attributed to the European Central Bank.

After a rocky start to his tenure as president of the ECB, Mario Draghi daringly declared in late-July 2012 that he would do “whatever it takes” to save the Euro. On July 24, the EURUSD had hit a two-year low at $1.2041, with the Italian 2-year note yield approaching 4.000% and the Spanish 2-year note yield approaching 6.000%. Within two weeks, the ECB had announced that it was discussing the technical details of a program to inject funds into secondary bond markets. On September 6, the ECB announced that it was creating the Outright Monetary Transactions (OMTs) policy, intended to “aim at safeguarding an appropriate monetary policy transmission and the singleness of the monetary policy.”

Essentially, the ECB was saying, “our monetary policy has been hindered because of high sovereign debt yields in the periphery, and if we are to properly stimulate the economies of the region, we’re going to need to bring down those borrowing costs.” This has been a very important development for investors’ psychology – the ECB had threatened to be the largest buyer in secondary markets if bonds kept eroding. The logic for any trader was simple: get out of the way. Italian and Spanish yields plummeted, and the Euro rallied.

In recent weeks, with Italian and Spanish short-term debt lingering at multiyear and all-time lows, the Euro hasn’t been able to appreciate, a surprising development. This speaks to the financial aspect of the crisis being resolved. But it also speaks to the economic aspect of the crisis, which remains a significant lingering problem. The unemployment rate has crossed the 25% threshold in Greece and Spain, and is well on its way towards 30%. In Italy, a fractured government, walking the tightrope of limited mandate, can do little to address the accelerating labor market erosion besieging Europe’s third-largest economy: the unemployment rate is now above 12%, the highest ever.

If labor markets need revival, what’s the best way to do so? To find jobs, of course! How do businesses get started or expand? By borrowing on credit from banks. This is especially true for small- and medium-sized enterprises, the foundation of Western-styled developed economies. As the crisis proliferates, Euro-zone banks have been unable to provide necessary financing. Enter the ECB, which unfortunately may be bad news for the Euro. That’s the catch-22 for the Euro and the ECB: in either case, the Euro may suffer and could very-well fall towards 1.2000 versus the U.S. Dollar by the end of the 3Q’13.

Part three of this series will expand on this post’s initial discussion of the ECB’s policies, with an explanation of how renewed efforts could negatively impact the Euro.

This is the first post in a series of four on recent economic, financial, and political developments in the Euro-zone rooted in the sovereign debt crisis. This first post will examine the financial aspect of the crisis.

The first several months of 2013 have been a far cry from the norm that developed in 2011 and 2012 for the Euro. While the past few years have been marked by heightened volatility for the Euro, shifting crisis management tactics have afforded the Euro-zone some time in getting its act together with respect to the sovereign debt crisis, now entering its fourth year of excess sensitivity. Case and point: the Euro was the top performing major currency on February 1, peaking at $1.3710 against the U.S. Dollar; now it finds itself fighting to stay near 1.3000.

While the EURUSD has traded around the psychologically significant 1.3000 level the past several weeks, it has been far from an uneventful journey to arrive at our current juncture.

Italy was back in the markets’ collective crosshairs beginning in late-February, when voters elected a hung parliament, ending the career of Center-Left candidate Pier Luigi Bersani, the man who many believed to be the centrist politician to lead the Euro-zone’s third-largest economy back from the brink. The bureaucratic logjam was resolved when Italian President Georgio Napolitano, having just been elected to an unprecedented second term, granted Enrico Letta privilege to form a government. Mr. Letta’s rise to the premiership has soothed bond holders – perhaps the most important part of the equation.

EUR:USD

Source: Bloomberg

Despite the Italian political crisis, the EURUSD has remained quite resilient, even overcoming a brief period of drama out of Cyprus. Given the relationship the EURUSD has held with short-term Italian and Spanish government debt, however, this isn’t a surprise. The chart above plots the EURUSD (white) against the Italian 2-year bond yield (orange – inverted Y-axis) and the Spanish 2-year bond yield (yellow – inverted Y-axis).

Back in August 2011, it was clear that the collapse in Italian and Spanish short-term bond yields (prices rallied) led the EURUSD higher off the low set on July 24 at 1.2041. Now, both Italian and Spanish short-term yields are at multiyear lows, with the former at all-time lows. This financial aspect of the sovereign debt crisis is no longer a problem for two major reasons, which is why the EURUSD has been able to sustain an elevated exchange rate thus far in 2013.

The one caveat: the ECB hasn’t had to actually use its ‘bazooka’ policy tool yet, the OMT. That’s why this is positive for the Euro: on a relative basis, the ECB’s balance sheet stays smaller than other central banks’. Thus, as long as the ECB can keep a lid on the financial aspect of the crisis without having to implement its version of QE, the Euro stands to benefit. So the big questions are: will the ECB implement its version of QE (or otherwise)?; and, what could provoke it to do so?

The next post in this series will examine the ECB’s role in the crisis, how it is evolving, and what policy changes in the future could mean for the Euro’s exchange rate. By identifying these factors, we’ll have a better idea of whether or not that Euro will appreciate or depreciate, and we’ll be able to decide if hedging this currency risk is necessary.

This post will discuss Chinese growth, the recent decline in base metals’ prices, and the outlook for the Australian and New Zealand Dollars.

The story of China’s “hard landing” is an easy sell: excess liquidity in the Chinese financial system, thanks to the People Bank of China’s massive expansionary monetary policy over the past few years, will stoke inflation; and then the PBoC will be forced to tighten policy too quickly, ensuring what is known as a liquidity trap, choking off growth far too rapidly.

But the naysayers have been proven wrong thus far. The 4Q’12 annualized Chinese GDP figure came in at +7.9% from 7.6% in the 3Q’12, and growth is expected to have a floor near +7.5%, according to estimates provided to Bloomberg News back in December. As always, we look to the PMI Manufacturing index, as well as base metals’ prices (the literal building blocks of society come from base metals), as forward indicator of Chinese growth prospects. The signs aren’t welcoming going forward.

Chinese PMI-manufacturing and iron ore spot

Iron Ore is a strong indicator of future growth prospects because it is required in the process to make steel; and steel, of course, is the preferred material to construct larger buildings, making it a popular resource in emerging market economies like China. Over the past several months, Iron Ore prices rallied quickly; but in February, prices have started to pull back as the Chinese PMI Manufacturing index has eased. Not only does this mean China could see slower growth going into mid-2013, but so too could Australia and New Zealand, as two regional economies for which China is their number one trading partner.

AUDUSD v RBA   NZDUSD v RBNZ

On their own, Australia and New Zealand are very different economies and countries. But in the broad context of global finance, their currencies are very alike – both are considered to be high beta commodity currencies, given the higher interest rates offered by their respective central banks. Considering where the market is pricing in rate expectations for the Australian Dollar over the next 12-months, it appears that the Australian Dollar is below fair value; on the other hand, the New Zealand Dollar is trading slightly rich relative to its interest rate expectations.

In the context of Chinese growth, Australia is more likely to be directly affected than New Zealand, so Iron Ore, Australia’s top export, serves as a strong proxy for growth hopes for China. At this point in time, given the signal in not just Iron Ore, but Copper as well (which has fallen back very sharply the past several weeks), it appears that the Australian and New Zealand Dollars could be poised for continued weakness throughout the 1H’13, before turning around and strengthening in the 2H’13, especially against the European currencies. The AUDUSD could decline into 0.9800 before rebounding back towards 1.0600, while the NZDUSD could fall towards 0.8000 before a move back to recent highs near 0.8500.

This post will discuss how revived regional political tensions have provoked the reemergence of the sovereign debt crisis, accelerating the timeline for significant Euro weakness from the 2H’13 into the end of the 1Q’13. We also explain why any calmness in markets will be as a result of the European Central Bank, and nothing more.

As we said in the first post in this series, coming into 2013, peripheral European sovereign yields remained low and relatively compressed to their German equivalents, allowing the Euro to outperform every major currency into February 1. But the journey from $1.2041 versus the U.S. Dollar on July 24 to $1.3710 on February 1 was not an easy one; at many points it appeared like the European Central Bank-induced rally was going to fall apart. This go-around, it may be time.

Post 7a image

With each tumble in the EURUSD in 4Q’12, there was an ensuing rally. But why not; the Federal Reserve had begun its QE3 program and the political situations from Greece to Spain were much calmer than they had been back in July. Yet everyone was very aware that the economics of the region (discussed last post) were remaining quite sour and in most cases, getting worse. Clearly, just as was the case with the rally in the S&P 500, there are other forces in play here driving confidence in the Euro, because a regional growth rate at its weakest point in the past five years is no reason to be bullish.

EUR/USD Spot

In order to buy governments time and bring down sovereign borrowing costs, ECB President Mario Draghi fulfilled his late-July pledge to do “whatever it takes” to save the Euro by pledging a liquidity program known as the OMTs, or Outright Monetary Transactions, which would effectively place a ceiling over Italian and Spanish yields for an unlimited amount of time, so long as budget consolidation was taking place.

Initially, similar to the impact that the Federal Reserve’s QE has had on the U.S. Dollar, the expanding ECB balance sheet size in early-2012 led to a sharp depreciation in the value of the Euro. But with bond yields tethered down and no additional liquidity injections required, the ECB was able to reverse the its balance sheet expansion by late-2012, and reduce its size in the beginning of 2013. While this initially led Euro strength over the past several months, sufficient evidence has gathered that the crisis may have been stirred.

The Italian elections that took place at the end of February emphasized how fragile the overall situation is in Europe: voters are becoming angry with their leaders, feeling as if supranational or even international powers are dictating policy. This is fitting, given the governments present in Greece, [especially] Italy, and Spain presently. Pandora’s Box has now been opened: 55% of the Italian electorate voted for the anti-austerity candidates, meaning that the Italian economic picture could worsen dramatically quickly once more, if investors lose faith in the bond market.

Greece and Spain are no “picnics” either. The Greek government remains highly unpopular and will likely head back to elections once German Chancellor Angela Merkel retains her chancellorship in the September German elections, while the Spanish government faces corruption charges and still puts off the necessary budget reforms desired by the core Euro-zone countries. We find there little reason to be bullish on the Euro, given the significant backdrop of European growth and political concerns, and wouldn’t be surprised in the slightest to see the EURUSD trade under 1.3000 for a sustained time (>3 months) in 2013.

This series of eight posts will focus on the major themes affecting currency markets. The eighth and last post in this series will review Chinese growth, performance of base metals, and forecasts for the Australian and New Zealand Dollars for 2013.

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