The harsh realities of the Greece-Eurozone game of chicken

Posted by Walter

The Greece-Eurozone dispute has received a great deal of attention in the media in recent weeks. It seems however that contradicting statements and polarized views -  many tainted by various political agendas - have created a great deal of confusion around the subject. As the parties resume negotiations this coming week, lets look at what each has to lose if a solution is not reached in time.

The damage to the euro area

First of all it's important to point out that the so-called "Grexit" is equivalent to a complete failure to pay on obligations by the Greek government, its banks, corporations, and households. While everyone is focused on the €315 billion Greece owes to the Eurozone, the IMF, and others, the damage to the euro area would actually be much greater.

Source: Bloomberg

What nobody wants to talk about is the fact that internally most Greek loans - including mortgages - are in euros (some are even in Swiss francs). Greek banks hold €227 billion of loans and €12.4 billion of Greek government debt (plus roughly another €25 - €50 billion of Greek-based private sector bonds). Under a Grexit scenario, most debt (including government debt) will be converted to the new drachma at a preset exchange rate.

As the drachma collapses - and there is little question that it will - Greek banks, who would now have drachma assets and euro liabilities, will quickly fail as well, leaving the Bank of Greece holding the bag. The Bank of Greece which is currently part of the Eurosystem will therefore default upon exit. But before it exits, the Bank of Greece will draw on Target2 from the rest of the Eurosystem as Greeks quickly move their deposits out (see how the mechanism works here with the Bank of Spain example). And there is no question Greeks will try to move a great deal of their deposits out before they are converted to drachmas. In December alone they pulled €4.6 billion euros out of Greek banks - and that's before the Syriza victory.

The default by the Bank of Greece could cause even more damage to the system than the losses to EFSF and to other entities such as the IMF. Between the government bonds the Eurosystem holds and the Target2 losses, the ECB may need to be recapitalized - a political disaster. Market anxiety alone could push the euro area back into recession as credit conditions tighten again (potentially similar to the Lehman situation).

In the long run, if Grexit becomes a reality, the whole EMU could become unstable. History certainly isn't on the euro area's side.

Source: @RBS_Economics

Of course the Greek membership in NATO and the nation's ports on the eastern Mediterranean that are strategically important to the West could be in jeopardy as well. In particular, Greece's recent interest in establishing a stronger relationship with Russia (see story) is scaring a number of NATO generals.

The damage to Greece

Greece is quickly running out of time. And it's not just the debt maturity wall in 2015.

Source:  @Eurofaultlines

We are talking about hitting the wall at the end of this month. Greek citizens are in the street these days with a new slogan "Bankrupt but Free". Of course it's all fun and games until pensioners line up at the soup kitchens and move into the homeless shelters because they can't get their retirement checks. It's a matter of weeks before Greek government employees no longer get their payments. Why is the situation so dire all of a sudden? Part of the problem is that the tax revenue is falling sharply now.

WSJ: - Government income has declined sharply in recent weeks as many Greeks have stopped paying taxes in hope that the country’s new, leftist government would cut taxes. Tax revenue dropped 7%, or about €1.5 billion euros, in December from the previous month and likely fell by a similar percentage in January, according to Economy Minister George Stathakis.

“We will have liquidity problems in March if taxes don’t improve,” Mr. Stathakis said.

Other officials warned the country would have difficulty paying pensions and other obligations beyond February.

And if the new government thinks their tax collection abilities will improve after Grexit, they are kidding themselves.

Furthermore, in the face of such uncertainty, Greek businesses will demand bags of drachmas for any goods and services they offer. And there is little chance that foreigners will accept drachmas for shipments of food, fuel, etc. With Greek government euro accounts frozen abroad after the default, access to hard currency will be cut off as the Bank of Greece will be forced to sell off its gold holdings. It's a humanitarian crisis in the making.

The compromise

Given such enormous risks to both parties a compromise will probably be reached. A bridge loan of some kind is likely in the nearterm. Beyond that we have some great unknowns and multiple rounds of "game of chicken" between the two parties.

One can sit around and pass the blame (see post) for the situation in which these parties find themselves today. But these are the harsh realities we are faced with and a longer term solution that softens the fiscal constraints on Greece while changing its liability structure will need to take shape. Otherwise the story of the European Monetary Union will enter its darkest chapter yet.

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Tough times ahead for the Swiss economy

The Swiss National Bank’s unexpected abandonment of the Swiss franc cap continues to reverberate across global markets (examples listed below). The currency settled around parity, which is about 17% above the cap (the euro is 17% lower). At this level the SNB loss on its massive foreign currency position (mostly euro) is somewhere around CHF 75 bn.

Note: The chart shows the EUR falling against CHF (CHF rising 17% above the cap level)

The buildup of euros was the result of having to defend the franc cap when capital was flowing out of the Eurozone into Switzerland (the SNB had to buy euros and sell francs). The central bank came under enormous criticism domestically for becoming so exposed to the Eurozone. But now the central bank is cutting its losses and walking away from having to buy any more euros.

In the past few years, the currency cap resulted in (relatively) easy monetary policy by keeping the franc artificially weak while the SNB balance sheet expanded via the euro purchases. While the mechanism was different than what we had with other central banks who have undertaken quantitative easing, the SNB's balance sheet had ballooned in recent years (see chart).  As a result, the nation’s stock market had outperformed other European markets by some 30% since the cap was instituted. When it comes to pumping up the stock market, easy monetary policy clearly works.

Source: @acemaxx  

But once the valve was opened and the Swiss franc was allowed to appreciate, the Swiss stock market gave up some 15% in just two days (chart below). In effect the SNB ended its version of “quantitative easing” in a few seconds rather than by “tapering” as was the case in the US.

Source: Investing.com

With this decision the SNB has lost a great deal of credibility - not due to the change in policy but due to its execution. The central bank looks divided, uncertain, and subject to political pressures.

Switzerland was already entering deflation before the currency was allowed to appreciate. Now the nation is about to undergo what Japan had a few years back. During the Eurozone crisis, the yen which - just as the Swiss franc - was a "safe haven" currency, strengthened significantly, nudging Japan into deflation. The situation in Switzerland is now similar, except that rather than easing policy further as the BOJ did, the SNB tightened it. For the Swiss economy difficult times lie ahead.

Examples of the fallout from the SNB's sudden policy reversal:

1. FXCM
2. Alpari UK
3. Everest Capital

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2015 will test the ECB's resolve and independence

In the Eurozone, manufacturing PMI reports last week were for the most part disappointing, as Italian manufacturing contraction unexpectedly accelerated (PMI < 50), while the French manufacturing sector has been in contraction mode for months now. With these poor manufacturing reports in the euro area, falling global commodity prices (see post), falling inflation expectations (see chart), and political uncertainty in Greece, German yields fell to new lows. On the first trading day of 2015, the 5-year Bund yield went negative for the first time.

And the 10-year yield fell below 50bp – also for the first time.

In fact, here is how the German yield curve now compares to that of Japan. The markets now expects the ECB's policy to shift closer to what has been implemented by the Bank of Japan.

Italian and Spanish bonds also welcomed the new year with a rally, as yields hit new lows.

Source: Investing.com

While these falling rates have become a daily occurrence, these market levels are unprecedented. That's why as 2015 opened, the euro fell to the lowest level since 2010.

The ECB is now under pressure to act - without a decisive bond-buying program over the next few months the euro area markets could face a sharp increase in volatility. That's something the area's nations can ill afford. The programs announced by the central bank thus far have been inadequate and a much more aggressive effort will be required to ease monetary conditions in the Eurozone.

Eurosystem (ECB) balance sheet (source: ECB)

However, a number of prominent politicians, particularly in Germany, will be increasingly critical of such efforts by the central bank - especially as risks around Greece keep resurfacing.

Reuters: - A senior member of Angela Merkel's party warned the European Central Bank not to pour money into Greece and other struggling euro zone states through bond purchases, saying this would reduce pressure on them to enact much-needed reforms.

Michael Fuchs, deputy parliamentary floor leader of the German chancellor's Christian Democrats (CDU), told Deutschlandfunk radio on Friday: "We shouldn't pump extra money into these states, but rather make sure they continue along the reform path.

"I'd be grateful if (ECB President Mario) Mr Draghi would make statements along these lines."

2015 is the year this conflict will come to a head as the ECB's reach, resolve and independence will be tested.

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Draghi now has all the ammunition he needs for QE. Implementation still a problem.

If Mario Draghi was lacking ammunition to initiate an outright quantitative easing program in the Eurozone, he certainly has it now. Even the staunchest opponents will have a tough time arguing against the need for a more aggressive approach to monetary easing. Here are five reasons:

1. The take-up on ECB's TLTRO offering (see post) fell far short of the ECB’s goals. Indeed the demand in the second round of the offering came in at €130 bn, putting the total take-up at €212bn - well below the €400 billion allowance. Since the TLTRO financing is linked to bank lending, the program to some extent relies on demand for credit from businesses and consumers. And that demand has been lackluster in the past couple of years. Therefore the initiatives announced by the ECB last summer, including ABS and covered bond purchases, are simply insufficient for the type of monetary expansion (of about €1 trillion) the central bank would like to see in the Eurozone.

Eurosystem consolidated balance sheet (source: ECB)

2. Some Economic data out of the Eurozone shows recovery stalling. Italian industrial production and French labor markets are just two examples.

Source: Investing.com

Source: Investing.com

3. With the collapse of oil prices, the Eurozone is bracing for deflation. German 5-year breakeven inflation expectations are now at zero. And Europe's central bankers are fearful of repeating Japan's decade-long struggle with deflation.

Source: @PlanMaestro

4. While the euro has declined significantly against the dollar, it remains quite strong on a trade-weighted basis. This is putting downward pressure on prices (via cheaper imports) and is disadvantaging some of the Eurozone-based exporters. A more aggressive easing effort would force the euro lower.

TWI = "trade-weighted index" (source: @TenYearNote)

5. Finally, the euro area's sovereign risks are resurfacing once again - triggered by new political uncertainty in Greece.

The Guardian: - Mounting concerns over Greece’s ability to weather a presidential election, brought forward in a surprise move by the prime minister, Antonis Samaras, continued to unnerve investors ahead of the first round of the vote in the Greek parliament next week.

Under Greek law failure to elect a new head of state by the ballot’s third round on 29 December could trigger a general election. The stridently anti-bailout main opposition party, Syriza, is tipped to win that poll. The radical leftists have made a debt writedown and the end of austerity their overriding priorities if voted into office.

Although Samaras called the election in a bid to expunge the political uncertainty engulfing Greece, the slim majority held by his government, compounded by the leader’s repeated warnings of Greece leaving the eurozone if Syriza assumes power, has accelerated investor nervousness.

The nation's stock market is down 20% over the past 5 days as investors flee.

red = Euro STOXX 50, blue = Athens Composite

And Greek sovereign debt sold off sharply. In fact the 3-year government paper yield went from roughly 3.5% in September to 11% now. This situation alone would make most central bankers consider some form of monetary easing.

Mario Draghi now has five solid reasons to argue for QE and many expect the central bank to announce such an initiative in the next 2-3 months. However, while most economists covering the euro area agree on the need to take a more aggressive monetary action, the problem of implementation remains. Since the Eurosystem's (ECB's) balance sheet is in effect owned by member states, many in the core economies are worried about having to become the proud owners of large quantities of their pro rata share of periphery nations' debt. For the Germans in particular, the ownership of such debt is a major issue. A solution that is even remotely politically palatable across the Eurozone remains elusive. The ECB's independence and the euro area's legal structure is about to be tested once again.

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Everything you wanted to know about the ECB's latest monetary policy (but were afraid to ask)

Once again, a great deal of confusion surrounds the European Central Bank's current policy objectives as well as the nearterm action expectations. Let's try to tackle the subject in a Q&A format.

Q:  Since the policy change announcement back in June, what has the ECB accomplished?
A:  In addition to lowering short-term rates, the ECB has launched the TLTRO program (4-year cheap loans to banks) and began its third covered bond buying program (these bonds are issued by banks and secured with loans).

Q:  What has been the impact of the ECB's interest rate reductions?
A:  The overnight benchmark rate has been set to near zero and the excess reserve rate has been moved to negative 20bp to incentivize banks to deploy capital. This has resulted in negative overnight interbank rate - banks pay each other to park their cash (which is still cheaper than parking cash with the ECB).

Overnight interbank rate in the euro area (source: emmi)

Furthermore, the euro's decline that resulted from negative rates and a possibility of further easing is expected to provide support for the export-dependent euro area nations.

Q:  Has the rate action resulted in more lending in the euro area?
A:  The immediate reaction of the area's banks to the negative deposit rate was to buy massive amounts of sovereign debt, including periphery bonds. This has resulted in unprecedented declines in government bond yields across the yield curve.

There is evidence however that credit conditions in the euro area are beginning to ease. Growth in broad money supply measures for example has improved markedly.

M3 YoY (source: ECB)

However, it remains unclear whether monetary policy had much to do with this development. Instead the banking system deleveraging cycle, which started a few years ago, is gradually ebbing. Moreover, the conclusion of the ECB's stress tests should help banks deploy more of their balance sheets in the private sector without the uncertainty surrounding the stress testing process hanging over them.

Q:  How much in TLTRO loans has been taken up by the banking system thus far?
A:  About €90bn - see story. This is well below some of the more conservative projections.

Q:  How much ABS (asset backed securities, such as credit card and auto loan receivables) and covered bonds has been purchased since the announcement of the program?
A:  The ECB has acquired a small amount of covered bonds but no ABS thus far - see schedule.

Q:  What has been the impact on the Eurosystem's (ECB's) balance sheet?
A:  The impact has actually been a net decline, as banks continue to repay their MRO and the original LTRO loans.

Eurosystem total balance sheet (source: ECB)

Q:  Why hasn't the ECB been able to buy more covered bonds and ABS in order to have a visible impact?
A:  According to Credit Suisse, the total amount of qualifying ABS and covered bonds the ECB could purchase is around €140bn. The volume is insufficient for the ECB to accumulate substantial amounts of paper without massively overpaying and disrupting this market. And even if the ECB did purchase that whole amount, it would take too long and have only a limited impact on the balance sheet expansion (note: this is roughly the amount of paper the Fed would buy in 2 months during QE3).

Q: There has been some talk of the ECB buying corporate bonds as well. Couldn't that help grow the balance sheet?
A:  Corporate bond purchases are a possibility, given the ECB can no longer afford to wait for the banking system to act as the area's policy transmission mechanism. According to Credit Suisse however, only about €100bn of corporate bonds would qualify/ be available for such a program. While it sounds like a large amount and would certainly cut borrowing costs for companies, the amount is insufficient to restore the Eurosystem's balance sheet to the 2012 levels.

Q:  How much then does the ECB need to expand its balance sheet in order to be credible?
A:  As discussed back in September, the ECB should probably grow the balance sheet by about €1 trillion. And the only way to achieve that is to augment existing programs with a more traditional QE effort that includes buying government bonds. Up to now there has been resistance from some Governing Council members (particularly) Germany, but supposedly Mario Draghi has been able to build consensus for such expansion - see story. That is why we had a rather sharp market reaction to the latest ECB press conference (see chart). Yet Draghi continues to downplay the €1 trillion balance sheet "target".

Credit Suisse: - ... ABS and covered bonds add up to €140bn-odd of potential purchases. Adding a (putative) €100bn of corporates is wildly insufficient to achieve the "target" [€1 trillion]. This target therefore has to be downgraded, in our view, to "something I believe I might have mentioned" while the much more thorny issue of "proper" (government) QE is addressed.

Q:  Why do many of the Governing Council members all of a sudden are convinced that such a drastic action (€1 trillion expansion) may be needed?
A: The persistently weak inflation readings have convinced them that Japan-style deflation risks in the Eurozone are quite real.

Source: ECB

Q:  When (if at all) will the ECB begin to purchase government bonds?
A:  The ECB is likely to wait on any traditional QE for some time, even though it has started to prepare for it (some ECB employees have been asked to dust off the old Securities Markets Program - SMP). The goal is to see if another round of TLTRO will meet with more demand and if inflation stabilizes on its own.

Q:  Will all this monetary activity by the ECB stem the declines in inflation?
A:  The technique used thus far has been to talk down the euro by hinting that a "bazooka" monetary event is on its way. That approach has worked. Whether the weaker euro will ultimately end up generating a higher sustainable inflation rate remains uncertain.

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Volatility returning to currency markets

Today the dollar gave up much of its Friday's gains that were driven by stronger than expected US employment situation report. We haven't seen such volatility in currency markets in some time. What happened?

Source: Investing.com

On one hand we have a developing story in the Eurozone as a number of economists continue to believe that the ECB will have to undertake government bond purchases. The central bank will probably need to increase the Eurosystem balance sheet by at least €1 trillion in order to be credible. But it will be impossible to purchase enough ABS and covered bonds without drastically distorting the markets. These markets and the TLTRO program just aren't sufficiently large to achieve such balance sheet expansion without a more traditional QE program that involves purchases of government bonds.

However Mario Draghi dampened expectations for a full QE program at the last ECB press conference. The explanation seems to be that Germany continues to be heavily opposed to such efforts. In fact Jens Weidmann is even opposed to ABS purchases - particularly from periphery states such as Greece and Cyprus. And some senior politicians in Germany are saying that Draghi is turning the ECB into "junk bank". With such headwinds for the ECB, it is not at all clear if QE will even be possible in the nearterm. Questions about the ECB's programs' effectiveness have introduced increased uncertainty into the euro's trajectory, causing volatility to rise.

Similarly the uncertainty is increasing around the Fed's liftoff as well. Expectations of timing vary dramatically between as early as Q1 of next year and as late as a year from now. With rate uncertainty comes increased currency volatility.

The volatility is further helped by the fact that speculative accounts have jumped on the long-USD bandwagon (as can be seen from the CFTC commitments of traders futures data).

Source: Timingcharts.com

Now add to that sharp swings in emerging markets currencies of nations such as Brazil, Russia, South Africa and Turkey and we finally see volatility returning to FX markets.


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Once again we wait for "shock and awe" from the ECB

The ECB (Eurosystem) balance sheet continues to decline as the LTRO/MRO loans to the banking system are repaid. We've seen a decline of about one trillion euros in the past year and a half.

Eurosystem consolidated balance sheet (source: ECB)

Anywhere else this would have been considered a massive tightening of monetary policy (imagine the Fed selling $1.3 trillion of bonds). But not in the Eurozone. In fact the area has experienced some significant easing recently. Both the euro and the long-term rates have fallen far below ECB's own forecast. The ECB achieved Japan-style easing without the Japan-style QE.

Source: Scotiabank

Source: Scotiabank

Near-term German rates are now firmly in the negative territory (see chart) - you now have to pay the German government to hold your money for 2-3 years. The central bank was able to loosen conditions while reducing its balance sheet as a result of unexpectedly soft economic reports from the area, falling inflation (see chart) and inflation expectations (see chart), as well as Draghi's jawboning.

The ECB got this round of easing "for free", but now markets will be expecting a follow-through from the central bank. And unless we get what amounts to "shock and awe" from the ECB, some of this easing (lower rates and lower euro) could see a sharp reversal.

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From our sponsor:

Market reaction to weakening fundamentals in Germany

The German business climate index tracked by the Ifo Institute declined more than expected this month, making it the 4th drop in a row.

The Guardian: - German business sentiment dropped for a fourth straight month in August as concerns about the Ukraine crisis and the effect of sanctions against Russia swept through corporate boardrooms in Europe's largest economy.

The Munich-based Ifo thinktank's business climate index, based on a monthly survey of about 7,000 companies, fell to 106.3 from 108, below the Reuters consensus forecast of 107.

A large part of the decline was of course due to the Ukraine crisis, but that was not the only cause of Germany's deteriorating private sector growth. Slowing exports to the rest of the euro area nations due to weaker demand as well as persistent economic headwinds in China (see discussion) have contributed as well.

This means that Germany is unlikely to support any further sanctions on Russia and will make a concerted effort to stabilize the situation (in spite of any pressure from the US).

The market reaction was swift, with the 10-year Bund yield hitting another record low.

Investors also piled into the three-year government notes, sending those yields into negative territory for the first time since 2012. The German government is now getting paid to hold your euros for three years.

In fact the nominal yield curve is in the negative territory all the way through the three-year point and showing signs of inversion - with the 1-year yield higher than the 3-year.

The euro dropped below 1.32, with rising expectations of diverging monetary policies between the US and the Eurozone. This was fueled in part by the Jackson Hole conference where Janet Yellen's speech was not as dovish as some had expected. The currency weakness will deliver some much needed relief for the euro area by helping the exporters and by providing some support to import prices. Currency weakness is one way to arrest deflationary pressures – the Japanese way.

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A look at today's ECB action - without the hype

In cutting through some of the media noise on today's action form the ECB, here are a few points worth discussing.

1. The negative rate on deposits would have been far more effective a couple of years ago when the Eurozone banks' excess reserves were a multiple of what they are now.

2. The end of sterilization of the SMP portfolio, bonds that the ECB had purchased a few years back (see discussion from Feb), will provide a boost to excess reserves. The current SMP balance is about €165bn - which is material relative to current excess reserve levels. Additional excess reserves will make the negative rate policy more effective.

3. The negative rate on deposits is sending banks into short-term periphery paper, as yields compress further.

Spain's 1y government bond yield (source: Investing.com)

It's important to note that excess reserves are a bit like a hot potato - you can pass them from bank to bank, but at the end of the day someone always gets stuck with them. That means some euro area banks will be making payments to the ECB of 0.1% on deposits. The Germans were quite upset about this - they feel that as far as their country is concerned the action will do more harm than good (see story).

4. The cut in ECB's main financing rate is basically symbolic. The problem with this near-zero rate is that if the ECB could set a separate rate for Germany vs. the rest of the member states, these rates would have been dramatically different. The so-called Taylor Rule, which models the "appropriate" interest rate, produces the following result.

Source: CIBC

This high discrepancy maintains tight conditions in "EZ ex-Germany", while risking asset bubbles in Germany due to a highly accommodate policy there. Here is an example.

Germany; Residential property prices, New and existing dwellings; Residential property in good & poor condition; Whole country (source: ECB)

5. The targeted approach to providing liquidity, the so-called TLTRO (€400bn), is a good idea.

Bloomberg: - Financial institutions will be allowed to borrow money from the ECB equivalent to as much as 7 percent of their outstanding loans to non-financial corporations and households, excluding mortgages.

The maturity will be up to four years, priced at the ECB’s benchmark rate when the loans are taken out plus 0.1 percentage point. Banks that don’t pass the money on will be obliged to repay it after two years. The so-called targeted longer-term refinancing operations, or TLTROs, will be carried out in September and December.

From March 2015 to June 2016, on a quarterly basis, banks will be able to borrow as much as three times the amount of their net lending to euro-area companies, above a threshold set by the ECB.

This creates incentives for banks to grow their "real economy" loan books. One of the problems with the Fed's QE program has been the weakening of loan growth (see post). Large firms and mortgage holders, who were able to refinance, certainly benefited from QE, but some of the biggest beneficiaries were asset management firms. That's why a targeted approach could prove to have more "bang for the buck"...

6. The ABS buying program is still in the works. There isn't sufficient amount of paper out there to have a large impact (see post), but we'll see what the central bank cooks up. They certainly have been quite creative.

7. Markets cheered, but the impact varied by asset class. The currency markets for example had a great deal of this ECB action already priced in  - and then some. The euro fell sharply on the announcements and then rebounded to finish up on the day.

Source: Investing.com

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From our sponsor:

Exogenous shock from artificially high euro

For the first time the ECB has admitted that disinflationary pressures present a problem for the central bank. Draghi is blaming the downward pressures on prices in the Eurozone on the unusually strong euro.

WSJ: - "The strengthening of the effective euro exchange over the past one-and-a-half years has certainly had a significant impact on our low rate of inflation and, given current levels of inflation, is therefore becoming increasingly relevant in our assessment of price stability," Mr. Draghi said Thursday in a speech in Vienna.

Indeed the euro has been strengthening beyond most analysts' expectations.

EUR/USD (source: Investing.com)

The euro's lofty levels, combined with softening demand from China (see post), is creating headwinds for the euro area. Part of the problem is that a good portion of the Eurozone's recovery has been driven by exports rather than domestic demand. Moreover, the yen's relative weakness is not helping matters, as Japanese exporters have a pricing advantage over Germany.

The confluence of the euro's strength and weak domestic demand is exacerbating disinflationary risks in the Eurozone - as seen in today's German CPI number.

Source: Investing.com

Ironically some of the euro rally is rumored to be the result of China's rebalancing its FX reserves toward the euro, trying to diversify out of the US dollar. That's driving up the euro to levels not justified by the fundamentals.

CNBC: - "While the technical outlook and European domestic fundamentals look quite shaky for the single currency right now, there could be one external factor that may help to prop up the single currency in the face of these challenges: China," said Kathleen Brooks, research director at Forex.com.

The timing for Draghi is terrible. The ECB has been arguing for some time now that disinflation in the area is transient. But this artificial euro strength could be creating an exogenous shock, potentially dampening the area's nascent recovery and putting further downward pressure on prices.

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From our sponsor:

Eurozone manufacturing expansion accelerates; risks remain

We've had some significant moves in the currency markets this morning. In particular, the euro rose quite sharply on the back of some strong manufacturing numbers out of the Eurozone.

Source: Investing.com

Germany remains the euro area's powerhouse, with manufacturing expansion there accelerating further, driving up the aggregate measure.

Source: Investing.com

European stock markets (followed by the US) however fell in spite of this seemingly good news.

The primary reason for the equity markets' sell-off was the weak manufacturing signals out of China (see Twitter post). As discussed here, China's near-term economic trajectory presents the greatest risk to global growth - particularly for the Eurozone.

The equity markets were also uneasy with the euro strength, which could choke exports from the area. Furthermore, Draghi struck a cautious tone with respect to the area's economic recovery, saying: "All in all, the risk of setbacks is large. I would be very careful not to give an overly optimistic outlook."

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From our sponsor:

Big inflows into gold ETPs generate a rally, but one should remain cautious

Gold lease rates declined across the curve in the last few days (flattening the forward curve somewhat). The bullish sentiment has forced some gold short-sellers out, reducing demand to "borrow" gold.

Source: Kitco

The bullish sentiment is visible in the recent jump in GLD shares outstanding, indicating significant inflows into gold ETPs.

GLD shares outstanding (Bloomberg)

Bloomberg: - Gold ETP holdings overtook France’s reserves on Aug. 21 after rising 90.4 tons this year to 2,447.1 tons, data compiled by Bloomberg show. Only the U.S., Germany and Italy hold more, International Monetary Fund data show. The IMF itself holds 2,814 tons of bullion, placing it between Germany and Italy.

Billionaire John Paulson raised his stake in the SPDR Gold Trust, the biggest gold ETP, by 26 percent in the second quarter and George Soros more than doubled his holdings, U.S. Securities and Exchange Commission filings showed Aug. 14. Investors will buy 150 tons through ETPs this year and next, Barclays Plc estimates.

In spite of the reductions in short positions and tremendous inflows into ETPs, gold has not yet reached a speculative frenzy such as the one that existed in the short euro positioning or investment grade bonds last month. Should gold become a "crowded trade", we would be able to see it in the futures markets net positioning.

Bloomberg: - The increase in prices and ETP holdings has yet to be reflected in speculative wagers in U.S. futures markets. Hedge funds and other money managers cut bets on a rally by 58 percent since the end of February, U.S. Commodity Futures Trading Commission data show. The net-long position fell 4 percent in the week to Aug. 14 and is near the lowest since 2008.

So far the long gold bet seems to focus primarily on global stimulus, particularly from the Fed (as well as the ECB and PBoC). And clearly not everyone is sold on this easing being timely or large enough to weaken the dollar sufficiently and generate material incremental demand for gold. In fact short-term downside risks to gold remain if the expectations of Fed's "QE3" prove to be wrong.

There is also talk that the Republican party is going to make the return to gold standard in the US part of their campaign agenda. According to some estimates, returning to gold standard would send gold prices to $10K/oz, which encouraged some recent retail buying.

WSJ: - The committee drafting the Republican Party's platform before next week's convention included a proposal to establish a commission exploring the United States' return to a gold standard.

Republicans in Tampa, Fla., citing President Ronald Reagan's commission "to consider the feasibility of a metallic basis for U.S. currency," this week included the creation of "a similar commission to investigate possible ways to set a fixed value for the dollar," according to language of the proposal provided by a Republican National Committee spokeswoman. The Reagan commission "advised against such a move," the proposal noted.

Doing so is a nice idea in theory but it simply can not be implemented. There isn't enough gold out there for the Fed to buy in order to support the USD monetary base ($2.56 trillion). And any attempt to do so will destroy the US international competitiveness. It is a purely political move on behalf of the GOP to appeal to Ron Paul's supporters (which is also a good idea, but is not going to translate into higher gold prices).

Chicago Tribune: - Instead of planning for a gold standard return, the Republicans are trying to placate supporters at next week's RNC and to gain more firepower in the party's promoting responsible U.S. fiscal and monetary policies in the upcoming federal elections in November, analysts said.

Minutes from the Federal Reserve's latest meeting suggests the U.S. central bank will adopt stimulus fairly soon unless economic conditions improve dramatically. Some expect Fed Chairman Ben Bernanke could use his speech at the central bank's gathering in Jackson Hole, Wyoming, at the end of this month to send a strong message to markets.

At the same time gold demand fundamentals (outside of the QE expectations and the gold standard idea) have been fairly weak.

Bloomberg: - Physical demand is slowing elsewhere, with sales of American Eagle gold coins by the U.S. Mint dropping 49 percent to 30,500 ounces last month, the lowest since April. The mint sold 21,500 ounces so far in August, data on its website show.

Gold imports in India, last year’s biggest buyer, are set to fall as much as 50 percent in the September to December period from a year earlier, Prithviraj Kothari, president of the Bombay Bullion Association, said Aug. 21. Local prices reached a record today, data compiled by Bloomberg show. That may crimp demand at a time when a below-average monsoon in the country threatens rural incomes.

Gold should be a part of a long-horizon diversified portfolio, particularly given the developed nations' central banks willingness to (over)compensate for their governments' inability to generate growth and improve labor markets. Japan and the UK central bank balance sheets are growing, the ECB is getting ready to do the same, and the FOMC seems to be "trigger happy" as well. But in the short-term, given the risk of "disappointment" from the Fed and even from the ECB as well as weak physical demand fundamentals (particularly from emerging markets), one should remain cautious.

SoberLook.com

Draghi sends crowded shorts running for cover

As discussed last weekend, the short euro position has been a crowded trade for some time now. Short Spanish and Italian debt and long treasuries and Bunds was getting there as well. To provide relief to Spain, Draghi threatened the markets. "Believe me, [my actions] will be enough [to hurt the shorts]".




In response, the euro went vertical with all the short covering.

EUR (dollars per one euro) intraday

There are not many "bullets in Draghi's gun", and threatening to do something major was one of them. He just used it. If there is no follow-through, his credibility is shot. Here is some commentary on the topic.

SoberLook.com