In a note this morning, Citi’s FX guru Steven Englander leads off with a great line on a subject that’s been a head-scratcher for many…
The Area 51 of the FX market is the why the euro has not fallen further given all the metrics on sovereign debt spreads, bank weakness and even two year yield differentials between the US and Germany.
Why has the euro remained so strong against the USD despite the well-known existential crisis threatening the currency.
In case you need a refresher, here’s a 3-year look at the Euro against the dollar. While it obviously has come down, it’s WAY ahead of its lows made last summer.
By way of comparison, below is a 3-year look at Italian yields, which are an excellent proxy for Eurozone stress and fears. The charts really don’t seem to have any relationship at all. Italian yields have worsened considerably over the last year.
So right off the bat, it should be clear that the Euro (as a currency) has not been a very reliable measure of how people feel about the Eurozone coming unglued.
And if you think about it, there’s no obvious reason why the euro as a currency should reflect fears of it going bust. If Greece left the euro, for example, would that make the remaining union stronger or weaker? It’s hard to say.
What’s more, crises can prompt some weird reactions in financial markets.
If you’re a European bank, and you’re worried about paying off your bonds, what are you going to do? You’re going to sell assets, and buy Euros (which is euro bullish!).
According to Englander, there has been some modest “repatriation” of Euros from European banks, as they shed their foreign assets to raise funds.
One proposed explanation is balance sheet contraction by European banks abroad and repatriation for the assets back to the euro zone. Recent capital flow data have given a mixed picture. If we look at French and German September capital flow data we find evidence of selling of foreign assets in both countries, so this is consistent with the repatriation idea. French investors have shown unusual prescience since the significant selling of foreign assets actually seems to have begun in June. There does not seem to be much repatriation in Germany, and in September foreigners were actually sellers of their German portfolio assets (after having been significant buyers in previous months). On balance September data seem to continue a trend rather than signal a new one.
In a note from the 15th, Deutsche Bank’s Alan Ruskin wrote a note titled: Repatriation = EUR area crisis without a EUR crisis?
Ruskin came to the same point, that the EUR is not a good measure of Eurozone stress, and that there’s a lot of Euro repatriation going on, especially at French banks.
Ruskin writes on Wednesday:
Today’s French balance of payments data was hugely revealing about the source of EUR strength. France’s data is the first glimpse of EUR area BOP trends in September, and suggests that the summer pattern of repatriation flows was no fluke.
Portfolio investment abroad (assets), that ‘normally’ has a negative sign indicative of outflows, has now had a positive sign, indicative of repatriation for 4 months – too long a streak to be put down to monthly noise.
Now one bearish case for the Euro is that when the ECB ultimately DOES decide to print money (as it must), then the euro will fall.
But not even this is obvious.
Going back to Citi’s Steven Englander for a moment, he writes…
Given the record in recent years, sustained, aggressive buying by the ECB would benefit the EUR more by risk reduction than it would hurt through lost credibility. It’s clearly not yet what the ECB wants to do, but if they do it in the big bazooka way, there will be a convergence trade that would help austerity, growth and debt sustainability. As a footnote, most clients see ECB buying as a euro positive, because they feel the contractionary forces are severe in the best of outcomes, although a decent minority see ECB buying as euro negative because of the perceived inflation risk.
Indeed, while the Euro is not a good measure of European sovereign stress, it is a fairly good measure of overall risk appetite.
That euro chart we posted earlier?
It actually looks a fair amount like a chart of the S&P 500 over the same period of time.
Bottom line: The euro is a good measure of overall “risk” appetite, but not a good measure of Eurozone stress, which is a little convoluted (especially since the two intersect), but the distinction is important enough to pay attention to.