ON-24H.blogspot.com
-------------------------------
Euro
This week witnessed another flareup in the eurozone sovereign debt crisis. As a result, volatility in the EUR/USD pair surged, by some measures to a record high. Even though the Euro rallied yesterday and today, this suggests that investors remain nervous, and that going forward, the euro could embark on a steep decline.
There are a couple of forex volatility indexes. The JP Morgan G7 Volatility Index is based on the implied volatility in 3-month currency options and is one of the broadest measures of forex volatility. As you can see from the chart above, the index is closing in on year-to-date high (excluding the spike in March caused by the Japanese tsunami), and is generally entrenched in an upward trend. Barring day-to-day spikes, however, it will take months to confirm the direction of this trend.
For specific volatility measurements, there is no better source of data thanMataf.net (whose founder, Arnaud Jeulin, I interviewed only last month). Here, you can find data on more than 30 currency pairs, charted across multiple time periods. You can see for the EUR/USD pair in particular that volatility is now at the highest point in 2011 and is closing in on a two-year high.
Meanwhile, the so-called risk-reversal rate for Euro currency options touched 3.1, which is greater than the peak of the credit crisis. This indicator represents a proxy for investor concerns that the Euro will collapse suddenly, and its high level suggests that this is indeed a growing concern. In addition, implied volatility in options contracts has jumped dramatically over the last week, which confirms that investors expect the euro to move dramatically over the next month.
What does all of this mean? In a nutshell, it shows that panic is rising in the forex markets. Last month, I used this notion as a basis for arguing that the dollar safe-haven trade will make a come-back. This would still seem to be the case, and should also benefit the Swiss Franc, which is nearing an all-time high against the euro. Naturally, it also implies that forex investors remain extremely concerned about a continued decline in the euro, and are rushing to hedge their exposure and/or close out long positions altogether.
Mataf.net suggests that this could make the EUR/USD an interesting pair to trade, since large swings in either direction will necessarily create opportunities for traders. While I have no opinion on such indiscriminate trading [I prefer to make directional bets based on fundamentals], I must nonetheless acknowledge the logic of such a strategy.
http://www.forexblog.org/2011/05/interview-with-arnaud-jeulin-of-mataf-net-try-a-lot-of-strategies.htmlPosted by Adam Kritzer | in Euro, Investing & Trading | No Comments »
Euro Nears Breaking Point
It’s deja vu all over again in the forex markets as another twist in the sovereign debt crisis has sent the euro tumbling by the greatest margin in nearly a year. It was only last month that I posted “The Euro (Still) has a Greek Problem,” and yet, forex markets are once again reacting to the possibility of a Greek default as thought it were a new development. At the very least, investors finally seem to be acknowledging the inevitable.
There have been several factors at work in this latest episode. On Monday, S&P downgraded its credit rating for Greece to CCC, following on a similar move by Moody’s. That means that Greece’s sovereign credit rating is now the lowest in the world, behind such eminent economies as Grenada and Ecuador. While the move was hardly noteworthy in itself, it represents one more straw on the camel’s back.
Greece’s government is increasingly unstable, and Prime Minister George Papandreou has become so desperate that he has suggested forming an alliance with Greece’s most powerful opposition party. Meanwhile, violent riots outside Greek Parliament have reportedly become a daily occurrence, as the Greek populace has proven unwilling to accept wage cuts and tax increases.
As if that weren’t enough, there is tremendous uncertainty surrounding the next stage of the Greek bailout. No one can agree on what amount to give and what should be stipulated in return. Some parties think that private investors should be involved in the bailout by taking a “haircut” on the bonds that they own. Some members of the eurozone are balking about contributing any funds at all, wary of justifying it to their own citizens and that it is merely forestalling the inevitable.
I think the NYTimes offered the best summary: “Funding fatigue is growing in the north European creditor countries, especially Germany, the Netherlands, Finland and Austria, just as austerity fatigue is mounting in Greece.” When you consider that Greek interest rates and credit default swap spreads have surged to record highs, it seems that default is really inevitable. If the IMF and European Union are so determined, they can push off default until 2013. Still, default now or default then is still default.
At this point, then, the only real question is what happens when Greece defaults. Will it be forced to leave the Eurozone? Will that push the rest of the Eurozone fringe closer towards default? Will the Euro collapse and cease to exist as a currency? What will happen then?
Unfortunately, I think the answer to all of these questions is yes. At the very least, Greece will be forced out of the eurozone. Bondholders will push interest rates in Ireland, Spain, and Portugal up to double-digit levels, trapping them in the same cycle in which Greece is currently ensnared. Given the exposure of French and German banks to the sovereign debt of financially troubled eurozone members, they will also require state bailouts, and so on.
In a recent op-ed published in The Financial Times, celebrity economies Nouriel Roubini argued that the only way to avoid a complete eurozone meltdown is if the euro depreciates rapidly “to restore competitiveness to the periphery” or if the European Union is able to rapidly achieve complete fiscal and economic union. Roubini argues that the former is difficult because of the ECB’s hawkishness, while the latter is precluded by political hurdles that remain too formidable to overcome.
As Greece inches ever closer to default, the markets will increasingly become gripped by utter uncertainty over the questions that I posed above. Central Banks will stop accumulating euro-denominated assets, and investment funds will similarly shun Europe. (In fact, there is already evidence that this is happening). While European interest rates are attractive relative to the rest of the G4, they are hardly enough to compensate investors for this uncertainty. And when the markets come to terms with this, the euro might finally reach its breaking point.
While I have written quite about forex correlations in recent posts, the focus has primarily been on correlations that exist between currencies. In this post, I would like to address a correlation that exists between currencies and other forex markets- specifically the relationship between the Euro and US stocks.
If you look at the chart above, you can see that an unmistakable correlation exists between the S&P500 and the EUR/USD that stretches back at least six months. Generally speaking, when the EURUSD has risen, so has the S&P 500, and vice versa. In fact, this correlation is so airtight that one analyst recently discovered that the two financial vehicles often reach intra-day highs and lows within minutes of one another!
Why is this the case? In a nutshell, it is because the Euro – especially relative to the dollar – is a proxy for risk appetite. The same is necessarily true for US stocks. When investors are confident in the strength of the global economic recovery and the possibility of crisis is distant, the euro will rise. This has nothing to do with fundamentals in Europe, which are probably at least as bad as they are in the US. Of course, it may be connected with dollar weakness, since it is arguably the case that quantitative easing has both depressed the dollar and buoyed US stocks.
As I intimated in the title of this post, however, the S&P recently decoupled from the euro. Since the beginning of June, US equities have declined sharply, to the extent that they have given back most of their gains in the year-to-date. The EUR/USD, meanwhile, continued rising all the way until last week. While this has happened on a couple previous occasions, this was perhaps the sharpest break between the two.
I’m personally at a loss to explain why this happened. It has been conjectured that the driving force behind the correlation is algorithmic trading, and that hence, it must also represent the source of the break. In other words, high-frequency traders – which account for an ever-increasing proportion of forex volume – tweaked their trading algorithms so as not to buy the S&P 500 when the EURUSD rises, and vice versa.
It’s probably also the case that S&P 500 was falling for endogenous reasons- specifically a decline in GDP growth and earnings expectations which need not necessarily reflect itself in a stronger euro. In fact, in a normal functioning market, you would expect an inverse correlation; strong US economic fundamentals should translate into both a strong dollar and rising stocks. Could it be that worsening fundamentals are manifesting themselves in the form of a weak dollar and weak stocks?
Alas, the correlation has re-established itself over the last week, which means this is largely a moot issue. At the very least, it’s still worth being aware of, both insofar as it remains intact and in the event that it breaks down again.
---------------------------------------
The Euro (Still) has a Greek Problem
Since the beginning of May, the euro has fallen by a whopping 7% against the dollar on the basis of renewed fiscal uncertainty in the peripheral eurozone. The optimists would have you believe that the markets will soon forget about the so-called sovereign debt crisis and just as quickly return their focus to monetary policy and other euro drivers. Personally, I think investors to follow such a course, as forex markets must eventually reckon with the seriousness of the eurozone’s fiscal troubles.
First, I want to at least acknowledge the primary sources of euro support. Namely, the European Central Bank (ECB) recently became the first “G4″ central bank to raise its benchmark interest rate; at 1.25%, it is now the highest among major currencies, save only the Australian dollar. Moreover, there is reason to believe that the ECB will hike further over the coming six – twelve months. First of all, eurozone price inflation continues to rise, and the ECB is notoriously hawkish when it comes to ensuring price stability. Second, Q1 GDP growth for the eurozone was a solid .8%, thanks to especially strong performances from France and Germany. While the ECB will likely follow the lead of the Bank of England and wait until Q2 data is released before making a decision, the strong Q1 performance is nonetheless an indication that the eurozone can withstand further rate hikes. Finally, Mario Draghi, who has been confirmed to replace Jean-Claude Trichet in June as head of the ECB, will need to effect an immediate rate hike if he is to establish credibility with the markets.
As I wrote in my last euro update (“Time to Short the Euro“), however, such a modest ECB interest rate – regardless of how it compares to other G4 rates – should hardly be enough to compensate yield-seekers for the risks associated with holding the euro for an extended period of time. Of course, the primary risk I am talking about is the possibility first of a full-fledged sovereign debt crisis, and secondarily of a eurozone banking crisis.
At this point, it is painfully obvious to everyone except for EU officials that the status quo cannot continue. Bailout funds cannot be expanded and rolled over indefinitely, especially since 3 countries (Greece, Ireland, and Portugal) are now involved. Greece, which is certainly the most pressing case, faces skyrocketing interest rates and declining interest from creditors, even as its budget deficit and national debt rise and its economy shrinks. Under these conditions, there is no way that it can re-enter private bond markets in 2012 (as was originally expected), if at all.
Thus, the only question is, what will happen instead? If Greece were to leave the eurozone, it could inflate away its debt, devalue its currency, and decrease interest rates. Regardless of its merit, this possibility has been vehemently dismissed because of concerns that it would lead to the implosion of the euro, and it seems very unlikely. What if Greece were to restructure its debt, by demanding concessions from bondholders? Based on the bond covenants, it apparently has wide latitude to do so, and might not even face legal repercussions. This possibility is also opposed by the ECB and EU officials because it would force banks to take massive [see chart below] write-downs on their debt holdings.
Greece could similarly elect to “re-profile”- basically lengthening the bond maturities (no “haircut” on interest and principal), ostensibly to give it more time to retool economically and fiscally. While this is a popular option, it probably would only succeed in forestalling the inevitable. Finally, the EU (with help from the IMF) could continue to loan money to Greece, in exchange for more additional austerity measures and collateralized by sales of state assets. Alas, this would be met with stiff political resistance from Greece. Not to mention that the recent indictment of Dominique Strauss-Khan – head of the IMF- on rape charges has jeopardized what has been the highest-profile advocate for continued support of Greece.
It seems inevitable that Greece will default on all or part of its debt. That’s not to say that this would cause its economy to collapse, nor that it would precipitate the end of the euro. In fact, recent history is full of cases of countries that successfully declared bankruptcy and emerged several years later unscathed. In this way, Greece could probably eliminate half of its debt, and significantly ease the burden that it poses.
Of course, this would not only set a dangerous precedent for Ireland, Portugal (and perhaps even Spain and Italy), but it would also reverberate throughout Europe’s banking sector, and would probably necessitate multiple bailouts. But what’s the alternative? Dragging out the crisis with secret meanings and feckless proposals will only add to the uncertainty. If Greece and the rest of the eurozone can come to grips with its collective fiscal problem, it will certainly cause chaos in the short-term and a further decline in the euro. By removing uncertainty, however, it will buttress the euro over the long-term and allow it to remain in existence.
Time to Short the Euro
Over the last three months, the Euro has appreciated 10% against the Dollar and by smaller margins against a handful of other currencies. Over the last twelve months, that figure is closer to 20%. That’s in spite of anemic Eurozone GDP growth, serious fiscal issues, the increasing likelihood of one or more sovereign debt defaults, and a current account deficit to boot. In short, I think it might be time to short the Euro.
There’s very little mystery as to why the Euro is appreciating. In two words: interest rates. Last week, the European Central Bank (ECB) became the first G4 Central Bank to hike its benchmark interest rate. Moreover, it’s expected to raise rates by an additional 100 basis points over the next twelve months. Given that the Bank of England, Bank of Japan, and US Federal Reserve Bank have yet to unwind their respective quantitative easing programs, it’s no wonder that futures markets have priced in a healthy interest rate advantage into the Euro well into 2012.
From where I’m sitting, the ECB rate hike was fundamentally illogical, and perhaps even counterproductive. Granted, the ECB was created to ensure price stability, and its mandate is less nuanced than its counterparts, which are charged also with facilitating employment and GDP growth. Even from this perspective, however, it looks like the ECB jumped the gun. Inflation in the EU is a moderate 2.7%, which is among the lowest in the world. Other Central Banks have taken note of rising inflation, but only the ECB feels compelled enough to preemptively address it. In addition, GDP growth is a paltry .3% across the EU, and is in fact negative in Greece, Ireland, and Portugal. As if the rate hike wasn’t bad enough, all three countries must contend with a hike in their already stratospheric borrowing costs, ironically making default more likely. Talk about not seeing the forest for the trees!
If the rumors are true, Portugal will soon become the third country to receive a bailout from the EU. (It should be noted that as recently as November, Portugal insisted that it was just fine and that a bailout wasn’t necessary). Its sovereign credit rating is now three notches above junk status. Today, Greece became the first Eurozone country to be awarded this dubious distinction, and Ireland is now only one downgrade away from suffering the same fate. Of course, Spain insists that it is just fine and denies the possibility of a bailout. At this point, though, does it have any credibility? Based on rising credit default swap rates (which serve as a gauge of the probability of default), I think that investors have become a little more cynical about taking governments at face value.
I have discussed the fiscal woes of the Eurozone in previous posts, and don’t want to dwell on them here. For now, I’d only like to add a footnote on the extent to which their problems are intertwined. Banks in Germany and France (as well as the rest of the EU) have tremendous balance sheet exposure to PIGS’ sovereign debt, which means that any default would multiply across the Eurozone in the form of bank failures. (You can see from the chart below that the exposure of the US is small, relative to GDP).
Some analysts insist that all of this has already been priced into the Euro. Citigroup Said, “The market is treating many of these [sovereign credit rating] downgrades as rearguard actions which are already well discounted.” Personally, I don’t think that forex markets have made a sincere effort to grapple with the possibility of default, which appears increasingly inevitable. In fact, when S&P issued a warning on the US AAA rating, traders responded by handing the Euro its worst intraday decline in 2011.
Any way you cut it, I think the Euro is overvalued. Regardless of what the ECB is doing, market interest rates don’t really confer much benefit to those holding Euros. Even if the rate differential widens to 1-2% over the next year (which is certainly not guaranteed, as Jean-Claude Trichet himself has conceded!) this isn’t really enough to compensate for the possibility of default or other risk event. Regardless of whether you want to be long or short risk, there isn’t much to be gained at the moment from holding the Euro.
on24h.blogspot.com
---------------------------------------------------
