A contrarian perspective on the short euro trade

As the euro continues to drift lower, it has become the accepted wisdom that we are headed for parity with the dollar.

Source: barchart.com

Indeed it is widely expected that the ECB will expand its securities buying program in size, duration and scope (the ECB has been exploring buying municipal bonds for example). The central bank is also expected to cut the benchmark rates, pushing deeper into negative territory. The chart below shows the Euribor futures trading significantly above par as the market expects sharply lower interbank rates.

Source: barchart.com

This of course differs sharply from the monetary policy in the US where markets now assign 70%+ probability of a rate hike next month (as discussed here back in October). There is no question that such divergent policy trajectories should push the euro lower. But has a great deal of this divergence been priced into the markets?

As the Euribor chart (above) shows, the market could now be "priced to perfection". The expectations for a "bazooka" new stimulus from the ECB are also manifested in the record low Eurozone bond yields. For instance, here is Germany's 5-year government bond yield which is clearly pricing in much more demand ahead.

These expectations have resulted in the short euro position becoming a crowded trade once again. The chart below shows speculative accounts' net euro futures positions. What happens if the announcement from the ECB is not quite the "shock and awe" that markets expect?

Source: Investing.com

What could push the ECB to come out with a more modest stimulus increase? Here are some possibilities.

1. In spite of the VW scandal and the Paris attacks, German business sentiment remains strong. The Ifo industrial sentiment exceeded economists' forecasts while the service sector climate hit record highs (below). While the China slowdown certainly created a drag on German GDP growth, the impact has not been as severe as many economists were expecting.

Source: Ifo

2. Moreover, we are seeing significant fiscal stimulus from Germany as the nation's government is addressing the refugee influx.

Source: Deutsche Bank

3. At the Eurozone-wide level we see the composite PMI also beat consensus, touching multi-year highs. The ECB has been known to monitor such PMI indicators.

Source: Markit/Tradingeconomics.com

4. The euro area credit situation is improving, albeit gradually. The deleveraging in the banking system has been over for some time as loan balances continue to grow.

Source: ECB (adjusted for sales and securitization)

We can see signs of stronger bank lending showing up in the Eurozone's broad money supply, which increased more than expected.

Source: Investing.com

5. Finally, the euro area's core CPI rose more than consensus in the latest report. While this is still far from the ECB's target, some central bankers looking at the chart below may want to pause before introducing massive amounts of new stimulus.

Source: Investing.com

This latest core CPI report will therefore increase pressure from some of the more hawkish council members to proceed with a more modest/gradual program when introducing new stimulus.

Jens Weidmann (FT): -  The core inflation rate stands at 1% and should gradually increase towards our definition of price stability, which is – let me remind you – a medium-term concept.

Crucially, the decline in oil prices is more of an economic stimulus for the euro area than a harbinger of deflation.

Lower oil prices reduce energy bills for both households and firms. That frees up financial resources which can then be put to use elsewhere – for consumption, investment or for reducing the debt overhang. All of this is good for the economies of the euro-area countries.

There is no question that the fundamentals for the euro remain bearish, especially vs. the US dollar. However, given some of the trends discussed above, a contrarian approach would suggest more caution on that crowded short euro trade.


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SoberLook.com

LIBOR is becoming less relevant, even in the US

The Barclays LIBOR scandal is expected to open doors wide open for private litigation. We know what that means for Barclays - the stock is down 11% for the day. But what does that mean for the LIBOR index?

It is possible that some banks will simply stop contributing to BBA in order to avoid running into similar problems in the future. Controlling flow of information across "the wall" (traders to contributors) in large institutions is difficult and expensive, and given that banks make no money by contributing, it may not be worth the risk.

As discussed before, this index is completely artificial in Europe. LIBOR/EURIBOR represents unsecured interbank lending which is not taking place among European banks, as they have almost entirely shifted to secured financing (repo) either with each other or increasingly with the ECB.

And even in the US where interbank unsecured lending still takes place, the market is becoming much less relevant. The chart below shows the total size of interbank loans for all US commercial banks going back to the 80s. The number is just over $100bn, which may seem like a large amount, but it's a fraction of what it was at the peak.

Interbank loans on balance sheets of all commercial banks
in the United States (4-week moving average, $MM)

What's even more striking is what this number represents as a fraction of the overall bank assets in the US (see chart below). Interbank loans are now just over 1% of total bank assets - the lowest in history. And there is some evidence that most of it is under one week in tenor. That means that even in USD, the 3-month LIBOR generally does not represent actual transactions.

Interbank loans as percent of banks' total assets
for all commercial banks in the United States (4-week moving average)

There are a number of reasons for this decline. Banks don't want the credit risk of lending to other banks when they can deposit money at the Fed who now pays them interest. Just as importantly banks don't want to rely on interbank borrowings for funding because that funding could disappear very quickly in a crisis.

Instead banks are increasing customer deposits (see this post for more info) because those tend to be far more "sticky". And regulators, rating agencies, and stock analysts prefer it that way.

We clearly need some alternatives to LIBOR that may represent actual transactions, ideally in an active market.

SoberLook.com

From EUR-LIBOR and Euribor to Eurepo - the only viable market index

Emails on an old Sober Look post discussing EUR LIBOR vs. Euribor indices continue to come in, with readers offering their explanations for the divergence between the two. As the chart below shows, the 3m Euribor to LIBOR spread is still elevated, now at about 7bp (7.7bp was an all-time high).

Euribor-EUR LIBOR (Bloomberg)

Besides a slight difference in the calculation, the best explanation continues to be the differences between the two “panel banks” that provide their quotes for the calculation. The Euribor panel includes a large number of eurozone banks.  The panel has for example 6 French banks, 4 banks from Spain, and 3 from Italy. It is generally believed that the eurozone banks would quote higher levels, since their increased funding needs will prompt them to pay higher rates. There is some evidence for that difference in the daily rate contributions.

Sample panel bank contributions: The US banks show lower levels than for example the French banks

The EUR LIBOR panel on the other hand is much smaller and has a higher percentage of US, UK, Swiss, and Japanese banks that may not have the same funding concerns and would therefore quote lower rates. At least that’s the theory behind this persistent spread.

Sadly, the reality has little to do with what many eurozone banks are actually quoting. Almost no material transactions have been done in term unsecured loans (which is what Euribor represents) for some time. The bulk of term interbank lending in the Eurozone is done on a secured basis, using repo. The European Banking Federation (EBF) has coined a name for the index that represents secured funding in euros. It is called the "Eurepo" and is calculated in a fashion similar to what's done for Euribor, using a panel of banks. Unlike Euribor however, which unfortunately is used to settle trillions of swaps and calculate interest on corporate loans, Eurepo actually represents a relatively active market in secured (collateralized) lending.

But in this crisis even the Eurepo transactions now function in less traditional ways. Rather than collateral being placed directly with a counterparty as is typically done in a repo transaction, many banks now prefer a triparty repo where the collateral is held with a third party. As Izabella Kaminska pointed out a while back, tri-party repo has become as common as the bilateral repo transaction in the Eurozone:

… the recent European crisis has now nearly completely vaporised what little unsecured interbank lending was left in the market. What’s more, the demand for tri-party transactions — where collateral is managed by a custodian rather than bilaterally — has almost doubled from less than 25 per cent before the Lehman crisis to almost 50 per cent since.

As the chart below shows, the Eurepo rates have been collapsing as the eurozone economies slow. This is what one would expect to happen to rates in this part of the economic cycle in the eurozone.

Eurepo rates (EBF)

The following chart shows the Eurepo yield curve. The spike at the 2-week point represents some premium for lending over the year-end as institutions do some "window dressing".  Again, this shows an actual supply/demand component of the market.

Eurepo yield curve (Bloomberg)

Going forward for any economists or risk managers who wish to look at true nominal short-term interest rates in the eurozone, Eurepo is the most representative index. On the other hand both Euribor or EUR LIBOR do not represent any actual market and therefore have little economic value or meaning.  Hopefully in the long term any instruments that currently use Euribor for settlement or rate calculations will shift to Eurepo.

SoberLook.com

EURIBOR vs EURO LIBOR

Something's rotten in the kingdom of LIBOR measuring organizations. Euro LIBOR, computed by the British Banker’s Association recently has been visibly below EURIBOR computed by the European Banking Federation. The two should be right on top of each other - both are surveys of major banks on term rates for wholesale Euro deposits. The chart below shows that recently we've had quite a spread between these.


EURIBOR - EUR LIBOR (bp)

source: Bloomberg


There are subtle differences in the calculations. LIBOR throws out the lowest and the highest quartile of the quotes, averaging out the rest. EURIBOR throws out the top and the bottom 15%. It is possible that EURIBOR includes some quotes that are quite high, which are excluded from LIBOR. It could be explained by a bank that is in need of significant Euro financing and is trying to attract wholesale deposits by quoting a higher rate.

This type of dispersion has not happened before to such extent. If anyone has a better explanation, we would love to hear from you: tips@SoberLook.com