The ECB has it successes but also plenty of problems

Let is continue the central banking season which allows us to end the week with some good news. As this week has developed there has been good news about economic growth in the Euro area.

The Federal Statistical Office (Destatis) reports that, in the third quarter of 2017, the gross domestic product (GDP) rose 0.8% on the second quarter of 2017 after adjustment for price, seasonal and calendar variations. In the first half of 2017, the GDP had also increased markedly, by 0.6% in the second quarter and 0.9% in the first quarter.

It has been a strong 2017 so far for the German economy but of course whilst analogies about it being the engine of the Euro area economy might be a bitter thinner on the ground due to dieselgate there are still elements of truth about it. But we know that a rising tide does not float all economic boats so ECB President Mario Draghi will have been pleased to see this about a perennial struggler.

In the third quarter of 2017 the seasonally and calendar adjusted, chained volume measure of Gross Domestic Product (GDP) increased by 0.5 per cent with respect to the second quarter of 2017 and by 1.8 per cent in comparison with the third quarter of 2016.

Of course Mario will be especially pleased to see better news from his home country of Italy especially at a time when more issues about the treatment of non-performing loans at its banks are emerging. Also this bank seems to be running its own version of the never-ending story, from the Financial Times.

A group of investors in the world’s oldest bank, Italy’s Monte dei Paschi di Siena, have filed a lawsuit in Luxembourg after it announced bonds would be annulled as part of a state-backed recapitalisation.

But in Mario’s terms he is likely to consider the overall numbers below to be a delivery on his “whatever it takes” speech and promise.

Seasonally adjusted GDP rose by 0.6% in the euro area…….Compared with the same quarter of the previous year, seasonally adjusted GDP rose by 2.5% in the euro
area.

Inflation

This is a more problematic area for Mario Draghi as this from his speech in this morning indicates.

According to a broad range of measures, underlying inflation has ticked up moderately since the start of this year, but it still lacks clear upward momentum.

This matters because unlike the Bank of England the ECB takes inflation targeting seriously and a past President established a rather precise estimate of it at 1.97% per annum. We seem unlikely now to ever find out how Mario Draghi would deal with above target inflation but he finds himself in what for him maybe a sort of dream. Economic growth has recovered with inflation below target so he can say this.

This recalibration of our asset purchases, supported by the sizeable stock of acquired assets and the forthcoming reinvestments, and by our forward guidance on interest rates, helps to maintain the necessary degree of accommodation and thereby to accompany the economic recovery in an appropriate way.

So we will get negative interest-rates ( -0.4%) for quite a while yet as he has hinted in the past that they may persist past the end of his term. Also of course whilst at a slower rate ( 30 billion Euros a month) the QE ( Quantitative Easing) programme continues. Even that has worked out pretty well for Mario as continuing at the previous pace seemed set to run out of German bonds to buy.

Consequences

However continuing with monetary expansion into a boom is either a new frontier or something which later will have us singing along with Lyndsey Buckingham.

(I think I’m in)(Yes) I think I’m in trouble
(I think I’m in) I think I’m in trouble

Corporate Bonds

When you buy 124 billion Euros of corporate bonds in a year and a few months there are bound to be consequences.

“Tequila Tequila” indeed. What could go wrong with this.?

OK, we are officially in la la land. A BBB rated company just borrowed 500 million EUR for 3 years with a negative yield of -0.026 %. A first..  ( h/t @S_Mikhailovich )

You can take your pick whether you think that Veolia is able to issue debt at a negative interest-rate or at only 0.05% above the swaps rate is worse.

Mario Draghi explained this sort of thing earlier in a way that the Alan Parsons Project would have described as psychobabble.

By accumulating a portfolio of long-duration assets, the central bank can compress term premia by extracting duration risk from private investors. Via this “duration extraction” effect, the central bank frees up risk bearing capacity in markets, spurs a rebalancing of private portfolios toward the remaining securities, and thus lowers term premia and yields across a range of financial assets.

Moral hazard anyone?

The dangers of this sort of thing have been highlighted by what has happened to Carillion this morning.

The wages problem

It is sometimes argued in the UK that weak wage growth is a consequence of high employment and low unemployment. But we see that there are issues too in the Euro area where the latter situations whilst improved are still poorer.

A key issue here is wage growth.Since the trough in mid-2016, growth in compensation per employee has risen, recovering around half of the gap towards its historical average. But overall trends remain subdued and are not broad-based.

Indeed if we look back to late May Mario gave us a rather similar reason to what we often here in the UK as an explanation of weak wages growth.From the Financial Times.

Mr Draghi also acknowledged concerns that sinking unemployment was not leading to a recovery in well-paid permanent jobs………….Mr Draghi said he agreed. “What you say is true,” he said. “Some of this job creation is not of good quality.”

The Italian Job

As I hinted earlier in this piece there are ever more signs of trouble in the Italian banking sector. There have been many cases of can kicking in the credit crunch era but this has been something of a classic with of course a dash of Italian style and finesse. From the FT.

Mid-sized Genoan bank Carige’s future looked uncertain this week after a banking consortium pulled its support for a €560m capital increase demanded by European regulators. Shares in another mid-sized bank Credito Valtellinese fell 8.5 per cent to a market value of €144m after it announced a larger than anticipated €700m capital raising to shore up its balance sheet.

There are issues with banks elsewhere as investors holding bonds which were wiped out insist on their day in court.

Comment

As you can see there is indeed good news for Mario Draghi to celebrate as not only is the Euro area seeing solid economic growth it is expected to continue.

From the ECB’s perspective, we have increasing confidence that the recovery is robust and that this momentum will continue going forward.

The problem though is where does it go from here? Even Mario himself worries about the consequences of monetary policy which has been so easy for so long and is now pro cyclical rather than anti cyclical before of course dismissing them. But unless you believe that growth will continue forever and recessions have been banished there is the issue of how do you deal with the latter when you already have negative interest-rates and ongoing QE?

Also the inflation target problem is covered up by describing it is price stability when of course it is anything but.

Ensuring price stability is a precondition for the economy to be able to grow along a balanced path that can be sustained in the long run.

Wage growth would be improved in real terms if inflation was lower and not higher.

Also Mario has changed his tune on the fiscal situation which he used to regularly compare favourably to elsewhere.

This means actively putting our fiscal houses in order and building up buffers for the future – not just waiting for growth to gradually reduce debt. It means implementing structural reforms that will allow our economies to converge and grow at higher speeds over the long-term.

Number Crunching

This from Bloomberg seemed way too high to me.

Italy’s failure to qualify for the soccer World Cup finals for the first time in 60 years may cost the country about 1 billion euros ($1.2 billion), the former chairman of the national federation said.

Me on Core Finance

http://www.corelondon.tv/2-uk-growth-cap-unreliable-predictive-bodies-bad/

 

 

 

 

 

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Let us continue to remember what has been inflicted on Greece

Yesterday the Financial Times revealed the results of an intriguing poll in Greece,

More than half of all Greeks agreed it was a mistake to have joined the euro. Barely a third of Greeks thought the euro wasn’t a mistake. Even among those who wanted to remain in the euro area at the end of 2015, fewer than half would have chosen to join again if given the chance to go back in time and warn their fellow citizens.

That survey took place almost two years ago. Since then, Walter finds that support for the euro has dropped by 10 percentage points.

Frankly I find it a bit of a surprise that even more Greeks do not think that joining the Euro was a mistake! But in life we see so often that some support the status quo again and again almost regardless of what it is. After all so many in the media and in my profession have sung along to Blur about Euro area membership for Greece.

There’s no other way
There’s no other way
All that you can do is watch them play

Regular readers will be aware that I have been arguing there was and indeed is another way since 2011. One of the saddest parts of this sorry saga has been the way that those who have plunged Greece into a severe economic depression accused those suggesting alternatives of heading for economic catastrophe.

If we look at the current state of play we see this.

The available seasonally adjusted data indicate that in the 2nd quarter of 2017 the Gross Domestic Product (GDP) in volume terms increased by 0.5% in comparison with the 1 st quarter of 2017, while in comparison with the 2nd quarter of 2016, it increased by 0.8%.

So economic growth but not very much especially if we note that this is a good year for the Euro area in total. So far not much of that has fed through to Greece although any signs of growth are welcome. To put this in economic terms this is an L-shaped recovery as opposed to the V-shaped one in my scenario. The horizontal part of the L is the fact that growth after the drop has been weak. The vertical drop in the L is illustrated by the fact that twice during its crisis the Greek economy shrank at an annual rate of 10% leaving an economy which had quarterly GDP of 63 billion Euros as 2008 opened now has one of 46.4 billion Euros. By anyone’s standards that is quite an economic depression.

Some good news

Here I would like to switch to what used to be the objective of the International Monetary Fund or IMF which is trade. In essence it helped countries with trade deficits by suggesting programme’s involving reform, austerity and devaluation/depreciation. The French managing directors of the IMF were never going to be keen on devaluation for Greece for obvious reasons and as to reform well you hear Mario Draghi call for that at every single European Central Bank press conference which only left austerity.

This was a shame as you see there was quite a problem. From the Bank of Greece.

In 2010, the current account deficit fell by €1.8 billion or 6.9% in comparison with 2009 and came to €24.0 billion or 10.5% of GDP (2009: 11.0% of GDP).

Even the improvement back then was bad as it was caused by this.

Specifically, the import bill for goods excluding oil and ships fell by €3.9 billion or 12.6%,

The deficit improvement was caused by the economic collapse. Now let us take the TARDIS of Dr. Who and leap forwards in time to the present.

In the January-August 2017 period, the current account improved year-on-year, as the €211 million deficit turned into a €123 million surplus.

This was driven by a welcome rise in tourism to Greece.

In August 2017, the current account showed a surplus of €1.8 billion, up by €163 million year-on-year………The rise in the surplus of the services balance is due to an improvement mostly in the travel balance, since non-residents’ arrivals and the corresponding receipts increased by 14.3% and 16.4%, respectively.

The Bank of Greece is so pleased with the new state of play that it did some in-depth research to discover that it is essentially a European thing.

In January-August 2017, travel receipts increased by 9.1%, relative to the same period of 2016, to €10,524 million. This development is attributed to a 14.5% rise in receipts from within the EU28 to €7,117 million,

I am pleased to note that my country is doing its bit to help Greece which with the weaker Pound £ might not have been expected and that Germans seem both welcome and willing to go.

as did receipts from Germany, by 29.0% to €1,638 million. Receipts from the United Kingdom also increased, by 17.7% to €1,512 million.

So finally we have some better news but there are two catches sadly. The first is that it has taken so long and the second is that Greek should have a solid surplus in terms of scale after such a depression.

Money Money Money

A sign of what Taylor Swift would call “trouble,trouble,trouble” can be found in the monetary system. The media world may have moved onto pastures new but Greece is still suffering from the capital flight of 2015.

On 26 October 2017 the Governing Council of the ECB did not object to an ELA-ceiling for Greek banks of €28.6 billion, up to and including Wednesday, 8 November 2017, following a request by the Bank of Greece.

The amount of Emergency Liquidity Assistance is shrinking but it remains a presence indicating that the banking system still cannot stand on its own two feet. This means that the flow of credit is still not what it should be.

In September 2017, the annual growth rate of total credit extended to the economy stood at -1.5%, unchanged from the previous month and the monthly net flow was negative at €552 million, compared with a negative net flow of €241 million in the previous month.

Also in a country where the central bank has official interest-rates of 0% and -0.4% we see that banks remain afraid to spread the word to ordinary depositors.

The overall weighted average interest rate on all new deposits stood at 0.29%, unchanged from the previous month.

Also we learn that negative official interest-rates are not destructive to bank profits and how banks plan to recover profits in one go.

The spread* between loan and deposit rates stood at 4.26 percentage points from 4.28 points in the previous month.

Comment

There is a lot to consider here but we can see clearly that the “internal devaluation” economic model or if you prefer the suppression of real wages has been a disaster on an epic scale. Economic output collapsed as wages dropped and unemployment soared. Even now the unemployment rate is 21% and the youth unemployment is 42.8%, how many of the latter will never find employment? As for the outlook well in the positive situation that the Euro area sees overall this from Markit on Greek manufacturing prospects is a disappointment.

“The latest PMI data continue to paint a positive
picture of the Greek manufacturing sector, with the
headline PMI signalling an improvement in
business conditions for the fifth month in
succession……….There was, however, a notable slowdown in output growth, which poses a slight cause for concern
going forward.

A bit more than a slight concern I would say.

Meanwhile I note that the media emphasis has moved on as this from Bloomberg Gadfly indicates.

Greece is taking a step closer to get the respect it deserves from Europe.

It is how?

Yields on the country’s government bonds, which have already taken great strides lower this year, hit a new low last week on news the government is preparing a major debt swap.

I have no idea how the latter means the former but let us analyse the state of play. Lower bond yields for Greece are welcome but are currently irrelevant as it is essentially funded by the institutions and mostly by the European Stability Mechanism. There are in fact so few bonds to trade.

So Greece will have an opportunity to issue debt more expensively than it can fund itself via the ESM now? Why would it do that? We come back to the fact that it would get it out of the austerity programme! Not quite the Respect sung about by Aretha Franklin is it?

 

Why have the bond markets lost their bark and their vigilantes?

The credit crunch era took us on quite a journey in terms of interest-rates. At first central banks reduced official short-term interest-rates in the hope that they would fix the problem. Then they embarked on Quantitative Easing policies which were designed to reduce long-term interest-rates or bond yields. This was because quite a few important interest-rates are not especially dependent on official interest-rates and may from time to time even move in the opposite direction. An example is fixed-rate mortgages. However if they are a “cure” then one day all the downwards manipulation of interest-rates and yields needs to stop. Of course the fact that it is still going on all these years later poses its own issues.

The United States looked as though it was heading on that road last year on two counts. Firstly the Federal Reserve was in a program to raise interest-rates and secondly both Presidential candidates indicated plans for a fiscal stimulus. When Donald Trump was elected as President he reinforced this by telling us this as I reported back on November 9th.

We are going to fix our inner cities and rebuild our highways, bridges, tunnels, airports, schools, hospitals. We’re going to rebuild our infrastructure, which will become, by the way, second to none, and we will put millions of our people to work as we rebuild it.

This was somewhat reminiscent of the “New Deal” of President F.D. Roosevelt although I counselled caution at the time and of course any fiscal expansion would be added to by the plan for tax cuts. The two impacted on bond markets as shown below.

There has been a clear market adjustment to this which is that the 30 year ( long bond) yield has risen by 0.12% to 2.75%.

In the US this tends to have a direct impact on fixed mortgage-rates as many places quote a 30 year one.

What happened next?

US bond yields did rise and in mid March the 10 year Treasury Note yield rose to 2.63% meaning that it was approaching the long bond yield quoted above. Meanwhile the long bond yield rose to 3.21%. However as we look back now those were twin peaks and have been replaced by 2.07% and 2.69% respectively.

Why might this be?

Whilst there does seem to be some sort of concrete plan for tax cuts there is little sign of much concrete around any infrastructure spending. So that has drifted away and there has been an element of this with official interest-rate rises. The US Federal Reserve has raised them to a range between 1% and 1.25% but seems to be in no hurry to raise them further. It does plan to reduce its balance sheet but the plan is very small compared to its size.

The Recovery

The US economy has continued to grow in 2017 as shown below.

Real gross domestic product (GDP) increased at an annual rate of 3.0 percent in the second quarter of 2017 (table 1), according to the “second” estimate released by the Bureau of Economic Analysis. In the first quarter, real GDP increased 1.2 percent. ( These are annualised figures )

This has not been enough to unsettle bond markets especially if we add in that so far in 2017 inflation has if anything faded. Here are the latest numbers from NASDAQ.

Excluding food prices and fuel, core PCE measure – the Fed’s preferred measure of inflation – increased 1.4% in July year over year compared with 1.5% in June. However, it edged up 0.1% in July on a monthly basis. Therefore, it is still far from the Fed’s target of 2%.

For once it does not matter if you use a core inflation measure as it comes to the same answer as the headline! Although the annual rate has only fallen by 0.2% for the core measure since March as opposed to 0.4% for the headline. But we are left with okay growth and fading inflation which gives us a reason why bond markets have rallied and yields fallen.

What about wages?

The various output gap style theories that falling and indeed low unemployment rates would push wage and in particular real wage growth higher have not come to fruition. From the Bureau of Labor Statistics.

From July 2016 to July 2017, real average hourly earnings increased 0.8 percent, seasonally adjusted. The increase in real average hourly earnings combined with no change in the average workweek resulted in a 0.7-percent increase in real average weekly earnings over this period.

Japan

If we stay with the subject of wages here is today’s data from Japan. From the Financial Times.

 

Unadjusted labour cash earnings fell 0.3 per cent year on year in July, down from a 0.4 per cent increase a month earlier, according to a preliminary estimate by the Ministry of Health, Labour and Welfare…….Special cash earnings, which includes bonuses, were down 2.2 per cent on the same month a year ago.

If we widen our discussion geographically and look at the US where there is some wage growth we see that in other places there is not as real wages in Japan fell by 0.8%. If we stay with Japan for a moment then we see that in spite of the media proclamations over the past 4 years that wages are about to turn upwards we are still waiting. Bonuses were supposed to surge this summer. So the “output gap” continues to fail and there is little pressure on bond yields from wage growth in Japan.

QE

This of course continues in quite a few places. In terms of the headline players we have the 60 billion Euros a month of the European Central Bank and the yield curve control of the Bank of Japan which it expects to be around 80 trillion Yen a year. I raise these points as a bond yield rally in these areas would require these to be substantially reduced or stopped. We expect little substantive change from the ECB until the election season is over but some were expecting a reduction from it as the Euro area economy improved. As time passes it will have to make some changes as its rules suggest it will run out of German bonds to buy next spring and the more it shuffles to avoid that the more likely it will run out of bonds to buy in France, Spain and even Italy.

Added to this are the sovereign wealth funds as for example Norway which seems to be rebalancing in favour of US Euro and UK bonds. There are also the investment plans of the Swiss National Bank.

Comment

So we see a dog that has little bark and has not bitten. Some of this is really good news as unlike the central banker cartel I am pleased that so far inflation has for them disappointed. Although as we look ahead there may be issues from some commodity prices. From Mining.com

December copper futures trading on the Comex market in New York made fresh highs on Tuesday after the world’s number one producer of the metal reported a sharp drop in production.
Copper touched $3.1785 a pound ($7,007 per tonne) in morning trade, the highest since September 2014. Copper is now up by more than 50% compared to this time last year.

So Dr,Copper may be giving us a hint although I also note that hedge funds are getting involved so this may be a “financialisation” move as opposed to a real one.

Another factor which would change things would be some real wage growth. Perhaps along the lines of this released by the German statistics office last week.

The collectively agreed earnings, as measured by the index of agreed monthly earnings including extra payments, increased by an average 3.8% in the second quarter of 2017 compared with the same quarter of the previous year. This is the highest rise since the beginning of the time series in 2011. The Federal Statistical Office (Destatis) also reports that, excluding extra payments, the year-on-year increase in the second quarter of 2017 was 3.4%.

If we move to my home country then it remains hard to believe with our penchant for inflation we have a ten-year Gilt yield of 1.01% as I type this. Even worse a five-year Gilt yield of 0.43% as you will lose the total yield in inflation this year alone. I can see how a “punter” might buy at times front-running events or the Bank of England but how can it be an investment unless you expect quite an economic depression?

 

 

 

What makes a currency a safe haven these days?

The subject of safe havens is something that comes to mind as one considers the situation concerning North Korea. An unhinged leader combined with nuclear weapons and intercontinental ballistic missile technology does not make for a stable mix and of course there is Kim Jong-Un to consider as well. Mind you Twitter took the news of a possible Korean H-Bomb very calmly yesterday as it was soon replaced in the headlines by Wayne Rooney’s difficulties and today events are led by a headline which could refer to North Korea but fortunately McStrike is in fact the first strike at MacDonald’s in the UK.

So let us consider an environment where risk is higher and maybe a lot higher. This poses an early issue as my time in derivative and particularly options markets taught me that we as humans are very bad at quantifying things to which we give a low probability. We are even worse when it is something we do not want to happen. Establishments magnify this issue as I recall the excellent work of the Nobel prize-winning physicist Richard Feynman on the NASA Challenger space shuttle disaster. He was part of the enquiry and was officially told that the odds were millions to one whereas when he interviewed individual engineers they told him that individual parts had a one in five hundred chance of failure. It turned out that the disaster was not a surprise as the surprise was that it had not happened before.

What does risk-off do now?

The Japanese Yen

Each time the rhetoric or a North Korean missile rises the Japanese Yen follows it. This felt especially odd when one of the missiles overflew Japan and tripped civil defence alarms as well as no doubt having the self-defence force scrambling. Also the rally to 109.60 this morning against the US Dollar will have steam coming out of the ears of the Bank of Japan on two counts. Firstly because a lower value for the Yen is part of Abenomics and secondly it will send equity markets lower ( 190 points on the Nikkei 225 index).Still the Bank of Japan will be able to occupy itself by buying yet more equities.

If we look deeper into Yen strength in risky times I note this from the IMF in November 2013.

since the mid-1990s, there have been 12 episodes where the yen has appreciated in nominal effective terms by 6 percent or more within one quarter and these coincided often with events outside Japan

Why might this be?

Safe haven currencies tend to have low interest rates, a strong net foreign asset position, and deep and liquid financial markets. Japan meets all these criteria

The first point if we modify low to lower to bring it up to date gives us food for thought on what determines interest-rates. We are usually told domestic considerations but there is a correlation between strong trade positions and negative interest-rates for example. As to the foreign asset position then unlike its public-sector which has lots of debt Japan is in fact the largest creditor. From Reuters.

Japan’s net external assets rose to their second-highest amount on record at the end of fiscal 2016, driven by rising mergers and acquisitions overseas by firms and portfolio investment, the Finance Ministry said Friday.
The net value of assets held by the government, businesses and individuals stood at ¥349 trillion ($3.12 trillion) — just behind 2014’s record ¥363 trillion. It meant Japan remained the biggest creditor nation for the 26th straight year, the ministry said.

There is a twist though as you might think the Yen rallies because of the money beginning to be brought home but in fact according to the IMF not so.

In contrast, we find evidence that changes in market participants’ risk perceptions trigger derivatives trading, which in turn lead to changes in the spot exchange rate without capital flows.

In essence it is expectations of a change rather than actual capital flows. I would imagine that the carry trade ( where foreign investors borrow in Yen) are a factor in this.

Swiss Franc

Many of the same factors are at play here which is why in the early days of this website I labelled the Yen and Swiss Franc as the “Currency Twins”. We can reel off negative interest-rates, trade, carry trade and so on including with a wry smile that official policy is in the opposite direction! There are two main differences the first is that there tend to be actual inflows into Swiss Francs. The second is the way that net private assets have been replaced by the Swiss National Bank. From a Working Paper from the Graduate Institute of Geneva

At the end of 2016, the Swiss net international investment position (NIIP, the value of foreign assets held by Swiss residents, net of liabilities of Swiss residents to foreign investors) reached 131 percent of GDP ……. The net international investment position of the private sector was thus close to balance in 2015, and only amounted to 24 percent of GDP at the end of 2016.

So we have seen something of a socialisation of Switzerland’s net investment position. Does that matter? I suspect so but markets seem less worried as the Swissy has rallied against the US Dollar by 0.75% to 0.9574 today.

Euro

It is hard not to raise a wry smile at the articles saying the Euro is no longer a safe haven currency as we note its rise today! Here is Kathy Lien of Nasdaq from last week with an explainer of sorts.

However the central bank’s positive economic outlook, their hawkish monetary policy bias

In future my financial lexicon for these times will have negative interest-rates and large QE as part of my “hawkish” definition. Anyway as we note that it is the countries with ongoing types of QE who are the new apparent safe havens we are left mulling the chicken and egg conundrum. Being a funding currency in the global carry trade is another consistent factor.

US Dollar

So far the era of the military dollar seems to have ended. Maybe it awaits a proper test as in an actual war but considering the stakes I would rather not find out.

Comment

So we see that a potential factor in being a safe haven currency is for official policy to be for the currency to fall? Not quite true for the Euro at least explicitly although of course it used to be expected ( outside the Ivory Towers who still do) that negative interest-rates and QE  weaken a currency. A side effect of the official effort is clearly that the QE and supply of money aids and abets those who wish to borrow in that currency and at times like this even if they do not actually reverse course markets price in that they might. The currency then sings along to “Jump” by Van Halen. You can turn the volume up to 11 Spinal Tap style if actual carry trade reversals happen.

Also there is the issue of what is a safe haven? In terms of Japan it is clearly not literal as it is in the likely firing line. We see that front-running expected trends remains the main player here as opposed to clear logical thinking. Also we see that another safe haven only flickers a bit these days as bond markets rally a bit but nothing like they used to That is another function of the QE era as how much more could they rise? Also I note that equity markets do not seem to fall that much as the FTSE 100 is off 10 points as I type this.

So a safe haven may simply be front-running? If so it means we need to dive even deeper in future as does this below for Switzerland show strength or potential weakness?

Specifically, assets held by Swiss residents abroad represent 671 percent of GDP, while claims by foreign investors on Switzerland amount to 541 percent of GDP. With this leverage, a movement in asset prices and exchange rates that affects more assets than liabilities has a sizable impact on the NIIP.

 

What are the consequences of a parallel currency for Italy?

This week has seen the revival of talk about a subject which has done the rounds before. It would also appear that you cannot keep Silvio Berlusconi down as he was the person bringing it back into the news! Here is what was put forwards according to the Financial Times.

Berlusconi said the right-wing Lega Nord’s proposal of introducing the so-called ‘mini-BoT’ (short-term, interest-free, small-sized government securities, a sort of ‘IOUs’ to be used as internal currency to pay government suppliers, taxes, social security contributions, etc) would not be too far from his idea of a parallel currency.

There are quite a few issues here but let us stick to the obvious question which is could it happen? The FT again.

Berlusconi’s point then is that a parallel currency could be launched entirely legally within the constructs of European treaties, with the ECB potentially powerless to intervene once the decision has been taken.

Either way, regardless of whether Italy goes down the path of an explicit parallel currency or the introduction of small-sized Italian government securities, it’s clear the will to break up the euro’s monopoly in Italy is growing.

According to Citi’s analysts more than two thirds of Italian voters currently support parties with an anti-euro stance.

An interesting view although of course likely to cause something of an Italian turf war as the current President of the ECB Mario Draghi told us this in July 2012.

And so we view this, and I do not think we are unbiased observers, we think the euro is irreversible. And it’s not an empty word now, because I preceded saying exactly what actions have been made, are being made to make it irreversible.

Of course the speech went further with the by now famous phrase below.

Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.

So there would be an especial irony should it be that Mario’s home country ends up torpedoing the whole project. Perhaps that is why his speech this morning refers back to 2012.

Investors had begun pricing redenomination risk into sovereign debt and interbank markets, as they worried about the possible break-up of the euro area.

And reminds us of his “Jedi Mind Trick” from back then.

This is why we announced Outright Monetary Transactions (OMTs) as an instrument that can support our monetary policy. The idea was for the ECB to purchase the sovereign bonds of countries affected by panic-based redenomination risk.

This brings us back to this week where Italian bond yields rose in response to such risk but only to 2.1% for the ten-year as I type this. So some 5% lower than the time of the Euro crisis and those selling Italian bonds would most likely be selling them to the bond buyers of the ECB. So in that sense Mario has played something of a blinder here especially if we allow for the fact that going forwards the ECB may purchase such bonds disproportionately ( partly because it is running out of German bonds to buy).

Some care is needed as on the face of it there is only one winner which is the “whatever it takes” ECB. But take care because if we dive a little deeper there is the issue of the ECB being backed by 19 different treasuries including the Italian one. What if people started to believe it would no longer be one of them? What would the other treasuries think about owning lots of Italian government bonds ( 283.7 billion Euros)? It would make the discussions with the UK look like a tea party.

How did this begin?

In essence the parallel currency thoughts came out of this summarised by Roubini’s Economonitor in July 2014.

Since 2008, Italy’s industrial production has shrunk 25 per cent. In the last quarter of 2013, while exports reached back to almost the same level as in 2007, household consumption was down by about 8 per cent and investment by 26 per cent, with a capacity loss in manufacturing hovering around 15 per cent. Between 2007-2013 employment fell by more than a million, and the unemployment rate more than doubled (Banca d’Italia 2014a).

So we have the issue of Italian economic underperformance which regular readers will be well aware of. Not only was economic output below that below the credit crunch peak it went below the level of the year 2000. On an individual level the position was in fact even worse as the population has grown in the Euro area and I recall calculating that economic output ( GDP) per head was in fact 7% lower than in 2000.

What about now?

Whilst the specific numbers this morning were for France and Germany the Markit PMI business survey hinted at more growth for Italy.

The rest of the eurozone saw a slightly weaker increase in output during the month, albeit one that was still marked. A slower rise in services activity outweighed stronger growth of manufacturing output.

This adds to last weeks official release.

In the second quarter of 2017 the seasonally and calendar adjusted, chained volume measure of Gross Domestic Product (GDP) increased by 0.4 per cent with respect to the first quarter of 2017 and by 1.5 per cent in comparison with the second quarter of 2016.

So we find an irony in that the parallel currency has been revived when Italy is doing better economically. The catch is that if we move to the individual experience and look at GDP per inhabitant we see the underling issue. In 2007 GDP per individual was 28.699 Euros and in 2016 it was 25876 Euros in 2010 prices.

Comment

There is a fair bit to consider here and the first is that parallel currencies are usually not approved by the government and may even be restricted or made illegal. Usually it is the US Dollar being used due to a loss of faith in the national currency although in an irony some places could use the Euro. We saw an example of the US Dollar being used in Ukraine for example. So the crux of the matter in many ways would be what would be legal tender in Italy going forwards and as someone observed when we looked at Bitcoin can it be used to pay taxes? Presumably this time the answer to the latter would be yes.

Next comes the interrelated issues of capital flight and currency depreciation or devaluation. I think that it is clear that large sums would leave Italy which poses the issue of whether a 1:1 exchange-rate could be maintained and for how long? I see no mention for example of what the official interest-rate would be? Moving onto debts such as bank debt and Italian government bonds or BTPs in theory the ECB could insist on repayment in Euros but in practice we come to the famous quote from Joseph Stalin.

“How many divisions does the Pope of Rome have?”

In the end it comes down to the words fiat and and faith. The first is easy as the government can make a law but will people not only have faith but really believe? Also in a way it is something of a side show ( Bob) because both pre and during the Euro what Italy has needed is reform and of course neither has delivered it. Mario Draghi reminds us of this at every ECB press conference.

 

 

 

 

The ECB faces the problem of what to do next?

Later this month ECB President Mario Draghi will talk at the Jackson Hole monetary conference with speculation suggesting he will hint at the next moves of the ECB ( European Central Bank). For the moment it is in something of a summer lull in policy making terms although of course past decisions carry on and markets move. Whilst there is increasing talk about the US equity market being becalmed others take the opportunity of the holiday period to make their move.

The Euro

This is a market which has been on the move in recent weeks and months as we have seen a strengthening of the Euro. It has pushed the UK Pound £ back to below 1.11 after the downbeat Inflation Report of the Bank of England last week saw a weakening of the £.  More important has been the move against the US Dollar where the Euro has rallied to above 1.18 accompanied on its way by a wave of reversals of view from banks who were previously predicting parity such as my old employer Deutsche Bank. If we switch to the effective or trade weighted index we see that since mid April it has risen from the low 93s at which it spent much of the early part of 2017 to 99.16 yesterday.

So there has been a tightening of monetary policy via this route as we see in particular an anti inflationary impact from the rise against the US Dollar because of the way that commodities are usually priced in it. I note that I have not been the only person mulling this.

Such thoughts are based on the “Draghi Rule” from March 2014.

Now, as a rule of thumb, each 10% permanent effective exchange rate appreciation lowers inflation by around 40 to 50 basis points

Some think the effect is stronger but let us move on noting that whilst the Euro area consumer and worker will welcome this the ECB is more split. Yes there is a tightening of policy without it making an explicit move but on the other side of the coin it is already below its inflation target.

Monetary policy

Rather oddly the ECB choose to tweet a reminder of this yesterday.

In the euro area, the European Central Bank’s most important decision in this respect normally relates to the key interest rates…….In times of prolonged low inflation and low interest rates, central banks may also adopt non-standard monetary policy measures, such as asset purchase programmes.

Perhaps the summer habit of handing over social media feeds to interns has spread to the ECB as the main conversation is about this.

Public sector assets cumulatively purchased and settled as at 04/08/2017 €1,670,986 (31/07/2017: €1,658,988) mln

It continues to chomp away on Euro area government debt for which governments should be grateful as of course it lowers debt costs. Intriguingly there has been a shift towards French and Italian debt. Some of this is no doubt due to the fact that for example in the case of German sovereign debt it is running short of debt to buy. But I have wondered in the past as to whether Mario Draghi might find a way of helping out the problems of the Italian banks and his own association with them.

is the main story this month the overweighting of purchases of rising again to +2.3% in July (+1.8% in June) ( h/t @liukzilla ).

With rumours of yet more heavy losses at Monte Paschi perhaps the Italian banks are taking profits on Italian bonds ( BTPs) and selling to the ECB. Although of course it is also true that it is rare for there to be a shortage of Italian bonds to buy!.

Also much less publicised are the other ongoing QE programmes. For example Mario Draghi made a big deal of this and yet in terms of scale it has been relatively minor.

Asset-backed securities cumulatively purchased and settled as at 04/08/2017 €24,719 (31/07/2017: €24,661)

Also where would a central bank be these days without a subsidy for the banks?

Covered bonds cumulatively purchased and settled as at 04/08/2017 €225,580 (31/07/2017: €225,040) mln

 

This gets very little publicity for two reasons. We start with it not being understood as two versions of it had been tried well before some claimed the ECB had started QE and secondly I wonder if the fact that the banks are of course large spenders on advertising influences the media.

Before we move on I should mention for completeness that 103.4 billion has been spent on corporate bonds. This leaves us with two thoughts. The opening one is that general industry seems to be about half as important as the banks followed by the fact that such schemes have anesthetized us to some extent to the very large numbers and scale of all of this.

QE and the exchange rate

The economics 101 view was that QE would lead to exchange rate falls. Yet as we have noted above the current stock of QE and the extra 60 billion Euros a month of purchases by the ECB have been accompanied for a while by a static-ish Euro and since the spring by a rising one. Thus the picture is more nuanced. You could for example that on a trade weighted basis the Euro is back where it began.

My opinion is that there is an expectations effect where ahead of the anticipated move the currency falls. This is awkward as it means you have an effect in period T-1 from something in period T .Usually the announcement itself leads to a sharp fall but in the case of the Euro it was only around 3 months later it bottomed and slowly edged higher until recently when the speed of the rise increased. So we see that the main player is human expectations and to some extent emotions rather than a formula where X of QE leads to Y currency fall. Thus we see falls from the anticipation and announcement but that’s mostly it. As opposed to the continuous falls suggested by the Ivory Towers.

As ever the picture is complex as we do not know what would have happened otherwise and it is not unreasonable to argue there is some upwards pressure on the Euro from news like this. From Destatis in Germany this morning.

In calendar and seasonally adjusted terms, the foreign trade balance recorded a surplus of 21.2 billion euros in June 2017.

Comment

There is plenty of good news around for the ECB.

Compared with the same quarter of the previous year, seasonally adjusted GDP rose by 2.1% in the euro area ……The euro area (EA19) seasonally-adjusted unemployment rate was 9.1% in June 2017, down from 9.2% in May 2017 and down from 10.1% in June 2016.

So whilst we can debate its role in this the news is better and the summer espresso’s and glasses of Chianti for President Draghi will be taken with more of a smile. But there is something of a self-inflicted wound by aiming at an annual inflation target of 2% and in particular specifying 1.97% as the former ECB President Trichet did. Because with inflation at 1.3% there are expectations of continued easing into what by credit crunch era standards is most certainly a boom. Personally I would welcome it being low.

Let me sweep up a subject I have left until last which is the official deposit rate of -0.4% as I note that we have become rather used to the concept of negative interest-rates as well as yields. If I was on the ECB I would be more than keen to get that back to 0% for a start. Otherwise what does it do when the boom fades or the next recession turns up? In reality we all suspect that such moves will have to wait until the election season is over but the rub as Shakespeare would put it is that if we allow for a monetary policy lag of 18 months then we are looking at 2019/20. Does anybody have much of a clue as to what things will be like then?

 

What is happening with the Swiss Franc?

One of the features of the credit crunch era has been the strength of the Swiss Franc. This has been for two interrelated reasons. The first is simply that Switzerland has been seen as something of a safe haven in these troubled times. The second as we have looked at many times comes from what was called the Carry Trade. This involved people and companies from other parts of the world borrowing in Swiss Francs because in something getting ever harder to believe interest-rates were much higher in their own domestic currencies than they were in the Swissy. In particular those taking out mortgages in some parts of eastern Europe with Hungary and Poland to the fore and also in places like Cyprus took out Swiss Franc mortgages to take advantage of the lower “carry” or interest-rate. The catch was the fact that there was an exchange rate risk which was obscured by the fact that the size of the trade put downwards pressure on the Swiss Franc ( and the Japanese Yen which was its currency twin in this regard). Accordingly it looked as if a financial triumph was on its way where interest-rate gains came with exchange-rate benefits. What could go wrong?

As the credit crunch hit there was a safe haven demand for Swiss Francs accompanied by some beginning to reverse their carry trades and the two reinforced each other. This meant that those who had taken Swiss Franc mortgages in eastern Europe found that the amount owed headed higher in their own currency and as the monthly repayments depended on the amount owed they headed higher too. The same happened to business borrowers. As more cut their losses the pressure was built up even more on those who remained. Meanwhile Switzerland was left feeling like a tennis ball bouncing around on a foreign currency ocean with consequences described the summer of 2011 by the Swiss National Bank like this.

The massive overvaluation of the Swiss franc poses a threat to the development of the economy in Switzerland and has further increased the downside risks to price stability.

It was afraid of a pricing out of the Swiss economy as it became less competitive. In September of that year it made something of a ground breaking announcement.

The Swiss National Bank (SNB) is therefore aiming for a substantial and sustained weakening of the Swiss franc. With immediate effect, it will no longer tolerate a EUR/CHF exchange rate below the minimum rate of CHF 1.20. The SNB will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities.

On that road the SNB became an enormous hedge fund with at the time of writing some 724.4 billion Swiss Francs in its foreign currency reserves. An odd consequence of this is that it would have welcomed this news overnight. From Reuters.

Shares in the world’s most valuable company surged 6 percent after-hours to a record of more than $159, taking its market capitalization above $830 billion.

As 20% of its assets are in equities the SNB will be happy and the last number I saw had it holding some 15 million shares in Apple. However even “utmost determination” apparently has its bounds as this told us in January 2015.

The Swiss National Bank (SNB) is discontinuing the minimum exchange rate of CHF 1.20 per euro. At the same time, it is lowering the interest rate on sight deposit account balances that exceed a given exemption threshold by 0.5 percentage points, to −0.75%.

So the full set had been deployed in terms of monetary policy of foreign exchange intervention and negative interest-rates. But it was not enough and the retreat by the SNB was followed by another Swiss Franc surge causing worries for not only Switzerland but more losses for those who had borrowed in it.

Ch-ch-changes

More recently there has been signs and hints of a possible crack in the dam of Swiss Franc strength. At the end of last week Bloomberg was pointing out that it was at its weakest since the January 2015 announcement and that this was driven by stop-loss buying from Japanese banks. Whilst my career has seen regular episodes of stop-loss buying by Japanese banks across many instruments which begs the question of whether they ever make profits this is an interesting connection between what were the two currency twins. CNBC summarised the situation like this.

The franc fell sharply against the euro in morning deals, trading at 1.13 Swiss francs, a three percent drop on the week. Against the dollar, it hit a month low of 0.9724 Swiss francs.

This morning has seen the Euro rise to 1.143 Swiss Francs as the new beat goes on.

Swiss Cheese

The Financial Times notes that the hole in Swiss cheese production may be in the process of being fixed.

 

Its competitiveness wounded by the strong Swiss franc, Switzerland has imported more cheese than it has exported in some recent months — an unhappy state of affairs for producers of Gruyère and Emmental. “It would be great to get back to a reasonable exchange rate,” says Manuela Sonderegger, of Switzerland Cheese Marketing.

A real world impact of the exchange rate moves although of course it will take a while for the weaker level of the Swiss Franc to have any significant impact.

Comment

There is quite a bit to consider here so let us look at what is in play. We cannot rule out that this is a consequence of thin summer markets but it is also true that a weakening has been in play for a few months. One initial driver may have been the strong phase of the US Dollar offering an alternative but the main player now is the Euro area. The better phase for it economically is now being accompanied by a stronger Euro signalled by the way it has moved above 1.18 versus the US Dollar and in a lesser way by the UK Pound £ being just under 1.12.

Thus the SNB will be hoping for a continuation of the stronger Euro and thus has a vested interest in the next move of Mario Draghi and the ECB. It will be hoping that it will withdraw more of its stimulus measures once the summer and indeed elections are over. Of course now the web gets increasingly tangled as the ECB will not be that keen on further rises in the Euro as it moves it reduces its “price stability” target. This particular currency war is now in the world of strength rather than weakness which of course sends another Ivory Tower or two collapsing as we note there is still 60 billion Euros a month of QE from the ECB.

Also if we look wider there will be implications. For example we may hear a sigh of relief from eastern Europe but also what if the rally continues and the SNB gets the chance to trim its reserves. As it has been a factor in driving equity markets higher would it be a sign of a turn? That is a fair way away from here but much more nearby has been the recent disarray in the claimed safe haven of Bitcoin. It makes me wonder if this has impacted the Swiss Franc but am struggling to think of a causal link.

Let me finish with another potential consequence which would be quite a change which would be an interest-rate rise in Switzerland. Could it get away from negative interest-rates before the next downturn strikes or is it trapped there?