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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Eurozone reacts to anticipated fed rate hike

Guest post by Marcello Minenna


Almost without warning, the Eurozone government bonds and the Euro experience spikes in volatility this past month. These abrupt movements are clearly correlated with the mayor announcements of a change in monetary policy by, initially by the ECB and then, by the FED. The European banks had been actively pursuing front-running strategies which try to anticipate ECB's moves until the beginning of Quantitative Easing program (PSPP). Not always with success, as experienced with the “flash crash” of April and June. The new game plan spectacularly backfired with the hawkish statement of Ms. Yellen during the FOMC of the 28th of October. This igniting a massive sell-off of Eurozone bonds with an intensity comparable to the previous “flash crashes”.

At the October 22 meeting, Draghi has clearly anticipated an acceleration of the monetary easing policies. He hinted at cutting the deposit facility rate (now at -0.2%) by at least 10 basis points and at increasing the pace of asset purchases. Finally, the ECB strongly suggested that the PSPP program may be extended for another 6 months. Both policy moves were designed to counter a strengthening Euro.

Figure 1.

In August it has become apparent to the European policy makers that a stronger Euro was having an adverse effect on the Eurozone’s balance of trade (Figure 2), thus harming the export driven recovery envisioned by the ECB.

Figure 2.

Since a rising currency was not seen then with favor by the ECB, the market began to evaluate a further monetary easing by the ECB as very likely, especially a reduction of the ECB deposit facility rate. This, in turn, resulted in the European banks resuming their hoarding of government bonds and pushing yields to very low levels in the following month. Even issues characterized by negative rates slipped below the deposit facility rate (Figure 3) thus becoming ineligible for the ECB purchase under the PSPP.

Figure 3.

This buying behavior would have made sense only if banks were expecting an interest rate cut. In fact, only bonds with a yield higher that the deposit facility rate are eligible for PSPP purchases: by lowering the deposit rate, the ECB is automatically widening the pool of purchasable bonds. In this scenario, the owner of the now eligible bonds would have been in the best position to exploit the jump in the value that one should expect due to the increased demand, as the ECB steps in.

Evidently, the chance of a rate cut was in the air. After the Draghi declarations, markets experienced a manic buying that has depressed yields to deep negative levels never experienced before (Figure 4 and Figure 5).

Figure 4.

Figure 5.

Clearly traders were pricing in the hinted cut of at least 10-15 basis points and were taking long positions on the short part of the Eurozone government term structures. The EUR / USD weakened accordingly, down of 20 pips.

Then, something happened that European banks were not expecting . At the FOMC meeting of 28th of October, MS Yellen released a hawkish view; expectations of a rate hike were brought forward to December. This can be easily appreciated by looking at the probability of a rate rise as inferred from the Futures' Prices on FED Funds (Figure 6). In a single day, the odds of a rate hike surged from 35% to 50%.

Figure 6.

This sudden reversal, from the previous FOMC meeting in September, had a clear impact on both the Euro and the ECB interest rate policy. The EUR / USD slipped another 20 bps; almost, instantaneously, the currency fell below the threshold of 1.1. This renewed trend towards a weaker Euro (-7% in two weeks, Figure 7) has unintended consequences for the front-running strategy of European banks: in fact less pressures on the exchange rate have given immediately more room to the ECB to delay or partially scrap the idea of a “QE on steroids”. Suddenly, the strategy of storing ineligible bonds with deep negative rates to front-run the future (but not so certain anymore) deposit rate cut was no longer attractive to Eurozone banks. A selling spree ensued immediately after Ms. Yellen’s speech.

Figure 7.

This pattern was further reinforced after the release of the stronger than expected data on unemployment and payrolls in the US for October. Traders adopted a 70% probability of a US rate hike in December. Predictably, the EUR / USD took another hit downwards of almost 20 bps. The sell-off of Eurozone bonds with negative yields accelerated in the following days (Figure 8).

Figure 8.

What will be the probable dynamics of the Eurozone government bonds in the coming weeks? As the ECB proceeds with the QE program, the pool of eligible assets will continue to shrink at a rapid pace; it’s not a case that the ECB is considering for purchases also municipal bonds issued by the main European cities. The illiquidity of a contracting market and the ever-changing expectations about the delivery of a QE 2.0 will surely put Eurozone bonds under further stress in the coming weeks.


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Plan B: the search for a solution to the Greek crisis

Guest post by Marcello Minenna



Yanis Varoufakis’ notorious Plan B is gaining notoriety as Greece’s ex-finance minister now faces criminal charges. Developed with James Galbraith of UT Austin, Plan B outlined the introduction of a "fiscal currency" parallel to the Euro in case of extended gridlock with the Troika. If the ECB cut off Emergency Liquidity Assistance to Greece this parallel currency would relieve Greece's tightened liquidity—and resulting social fallout—during an extended bank holiday. Some still say much ado about nothing but is this really the case?

Such supplemental currency is uncharted territory for Eurozone Treaties as it would be denominated in euro and would not represent a new currency or the return to the Drachma. Under Plan B Greece could have introduced a de facto system for accounting and transferred household debt owed to Greece’s tax authority to third parties. Once this debt is transferable, Greek citizens could use the newly issued currency to settle transactions: citizens could simply transfer debts for goods and services as they do with traditional currencies. Moreover the Varoufakis-Galbraith plan would have allowed residents to exchange new currency for funds otherwise frozen in bank accounts. Consequently, restored financial transactions would have bypassed liquidity issues and the stifling bank holidays.

The successful circulation of a fiscal currency depends on household debt owed to the tax authority. Debt-based currency issuance, which depends on substantial household debt owed to the sovereign tax authority, would be particularly effective in Greece given the high level of fiscal indebtedness of its citizens . In fact Residents have high fiscal debts and the banking system has recently been recapitalized by about 50% using € 15 billion of Deferred Tax Assets. In other words, such a plan has already been used to keep Greek banks alive and preemptively prevent the Troika from meddling with Greek bank accounts in the future. Similarly, Greece could circulate Public Administration debt owed to the private sector. It is unclear whether Syriza could extend this mechanism to future fiscal debt given the heavy haircut for converting fiscal currency to Euros.

To implement the fiscal currency the Greek government would have used taxpayer information available at the General Secretariat on public revenues. While Greece could easily access such information in normal economic conditions, the necessary management software was provided, and likely controlled, by the Troika. Greece’s creditors would obviously prevent their diffusion of a fiscal currency that would allow Athens to take control of their national monetary base. If implemented, the policy measure would both strengthen Greece’s position in the negotiations and any possible plans of last resort. such as the exit from the Euro, less daunting. Varoufakis has recently highlighted that, with a fiscal currency implemented, the return to the Dracma would been realizable with just a "round of a hat".

However the fiscal currency is not a panacea: it would preserve public order but not to amend Greece’s contracting GDP, consolidated deflation, and their much-feared consequences on debt servicing. Moreover, the fiscal currency would facilitate domestic transactions but be ineffective for international credit payments such those for public debt (about € 320 billion, 180% of the GDP).

The search for a solution to the Greek crisis needs to take a broader perspective. In particular, the Eurozone leadership should seek three goals: reduce sovereign debt spreads between member nations, encourage fiscal transfers that correct financial imbalances and the competitive gaps triggered under the Euro, and help structure effective debt relief for Greece by restructuring at market value.

Just recently, this trio helped Puerto Rico reconcile untenable debt, culminating in default. The negative effects on Puerto Rican GDP measured just one third of those on Greece. Although Puerto Rico is only a US territory but not a State of the Federation, it has benefited from federal transfers more than five times the Eurozone allocated to Greece—a member State of the European Union in every respect. While, the FDIC handled Puerto Rico’s banking crisis under the federal budget for more than $ 5 billion, the EU must help Greek banks recapitalize more than € 25 billion at the expense of depositors.

DTAs in the balance sheet of the main Greek banks (2011-2014)

Weekly Evolution of the Emergency Liquidity Assistance ceiling to Greek banks
(February – August 2015)

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Troika to extend the unsustainable Greek debt by decades

The Euorzone leadership remains uneasy with the third bailout of Greece. This unease can be seen in the recent delay to the start of the negotiations, with the Troika staff in Athens siting "technical issues". The actual reason has to do with the fact that Greece's creditors have yet to reach an agreement among themselves. Apparently some Eurozone nations are still pushing for additional requirements that go beyond the austerity measures the Greek parliament recently passed.

The challenges surrounding the new bailout are severe. The intrusive nature of reform enforcement by the creditors is likely to worsen the already intense animosity in Greece toward the Troika institutions.

Bloomberg: - Previous memorandums committing Greece to enforce reforms on everything from the rules of bank recapitalizations to evaluating the “impact of the changes in milk pasteurization and sale procedures,” have prompted dissenters to claim that Greece has turned into a “debt colony.” Creditors argue that changes are necessary to stabilize the country’s finances and set it on course to sustainable growth.

Furthermore, the negotiations will once again be taking place "under the gun" as the next payment to the ECB of over €3bn is due on August 20th.

Assuming the deal will be completed in August as the can gets kicked much further down the road, Greece is being set up for a massive maturity wall, with little chance of principal repayment. And any form of debt principal forgiveness is off the table.

Natixis: - [Greek debt forgiveness] is unlikely to come about given the opposition of many Member States (Germany notably), the position of the Eurogroup over this issue (“nominal haircuts on the debt cannot be undertaken”) and the legal obstacle (measure would be in breach of Treaty). Under these conditions, this leaves one option, namely a re-profiling of Greek debt without touching the principal.

Out of the EUR82bn-EUR86bn lent by the ESM, part could be applied to repurchase the debt held by the ECB and to repay early the IMF (which in total would represent EUR25bn). [It] follows that the financing requirement of the Greek State, assuming there is a 20-year grace period and repayments are spread over 40 years, would correspond to the primary balances and repayments of principal and interest in respect of market debt held by private creditors (i.e. TBills, GGB PSI, new GGB and debt issued under foreign law)

According to Natixis here is what the liability term structure is expected to look like after the completion of this third bailout. How Troika lenders can possibly get comfortable leaving a small nation with this type of a debt profile is unfathomable. And yet, this is the most likely outcome of the upcoming negotiations.

Source: Natixis

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Managing Greek default risks

Many in Europe continue to believe in the permanence of the Eurosystem. The Bank of Greece is controlled by the ECB and its assets and liabilities will always be consolidated into the Eurosystem. By this argument, the collateral held by the Bank of Greece as part of the ECB's financing of Greek banks belongs to the Eurosystem. Therefore if the Greek banking system were to fail, at least the Eurozone's central banking system can keep the collateral.

Let's be clear: if Greece were to exit the currency union, the Bank of Greece and its assets would be immediately expropriated by the Greek government (making them part of the "new" Bank of Greece). Many in Europe are pointing out how such action would be illegal. There nothing "legal" about Grexit to begin with - the system was designed to have laws for "marriage" but no laws for "divorce". And with the Bank of Greece exiting so would go the collateral. To assume that the Bank of Greece is a permanent fixture of the Eurosystem is not prudent credit risk management. Therefore the Eurosystem's exposure to Greece should be added to the €323bn of other debt.

Having said that, Target2 debt owed by the Bank of Greece to the Eurosystem has no maturity and requires no immeduate payments. Therefore a standalone Bank of Greece may choose to keep the liability outstanding in order to get access to the euro payment system. The Eurozone's political leadership may however demand a timely repayment of these balances, given the size of the exposure.

Source: Barclays Research

This central-bank-to-central-bank exposure is now rising rapidly as the ECB approves a new limit increase for emergency funding (ELA) on a daily basis. This is what a run on the Greek banking system looks like.

Source: Barclays Research

While some accounts are moving abroad and into other assets (including European bonds held in foreign accounts and even into bitcoin), much of the withdrawal activity is simply converting deposits into banknotes. Anecdotal evidence suggests that many in Greece are leaving a minimal amount at the bank to keep the account open and the rest is in cash stored under the kitchen tiles, etc. Greece is quickly becoming a cash economy. Capital controls could be the next logical move by the Greek government and the population and businesses are simply protecting themselves.

Source: Barclays Research

Here is an example:

Bloomberg: - Dorothea Lambros stood outside an HSBC branch in central Athens on Friday afternoon, an envelope stuffed with cash in one hand and a 38,000 euro cashier’s check in the other.

She was a few minutes too late to make her deposit at the London-based bank. She was too scared to take her life-savings back to her Greek bank. She worried it wouldn’t survive the weekend.

“I don’t know what happens on Monday,” said Lambros, a 58-year-old government employee.

There is hope however for a less-than a disastrous outcome. These near-panic conditions could be sufficient to bring the nation's leftist government back to the negotiating table this weekend. However, time is fast running out as €1.6bn is due to the IMF in less than 10 days.

Moreover, there is a good possibility that Greece could default without leaving the currency union. With a strong support for the euro, Greeks could push for a referendum to form a more centrist government that would re-engage the creditor institutions. Here is a summary from Barclays Research:

Source: Barclays Research

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Shedding light on recent bond volatility in the Eurozone

Guest post by Marcello Minenna


Typically the technical details of open market operations of the central banks are not known. The unpredictability prevents in fact opportunistic behaviors of banks and alterations in market microstructure.

The ECB’s Public Sector Purchase Program (PSPP) ignores these principles with the following results:

• bank lending tends to zero;
• the interest rate volatility of the Eurozone Sovereign Bonds (EZ govies) has considerably increased;
• banks have achieved almost 13 billion euros of capital gains in return for their national central banks (NCBs).

The first point is self-explanatory and the evidence can be found in the data published by the ECB in April 2015 (https://www.ecb.europa.eu/press/pdf/md/md1504.pdf ); QE at least for now is not loosening the credit crunch.

The second point simply comes from an analysis of the options implied volatility on Bund's futures.

With regards to the estimates of the banks' capital gains, some further considerations are required.

First, the fact that bonds with yields lower than the deposit facility rate are not eligible under the PSPP.

The reason of this floor is to avoid that through the monetary policy there could occur undue fiscal transfers within the system. To explain this let’s consider first what happens in a simplified currency area where we have only one Central Bank and one private bank. The private bank sells a bond to the Central Bank, let’s say at 100 euros, and this bond has a coupon rate of 5%. Hence, by buying the bond the Central Bank receives a coupon of 5 euros. The private bank pours the money cashed (from selling the bond) on its deposit account at the Central Bank and it gains a yield on the money deposited. In order to avoid that the Central Bank would experience a loss obviously the deposit account should pay at most an interest of 5%. Let’s move now to the present situation where interest rates are negative and, hence, we have to fit a little bit the reasoning as follows. The Central Bank buys from the private bank the bond at premium (that is with an implied negative coupon) meaning that the Central bank gets losses due to this investment. On the other side it gets a gain from the negative yield on the deposit account of the private bank (currently -0.20% within the Eurosystem). From the point of view of the Central Bank this game rules out losses as long as the interests it receives on the deposits of the private bank are higher or equal to the implied coupon of the bond purchased. Hence it is clear why the PSPP requires that the eligible Govies should have yields higher or equal to -0.2%.

It is also helpful to understand intuitively where the capital gains of private banks come from.

To this purpose, it has to be observed the evolution of the yields’ term structure of the two major member countries of the Eurozone from the PSPP’s first informal announcement (of the 18 November 2014) and up to the 20 April 2015, date on which their yields have reached their all-time low.

There is no doubt that those who had in their portfolio Eurozone sovereign bonds wouldn’t have had no difficulty in achieving capital gains within of a Eurosystem as redesigned by the QE.

Within the core Eurozone countries since mid-April – that is in an environment of zero (or even negative) rates,  with less and less eligible securities for the PSPP, with vanishing liquidity in the secondary market and with new bullish expectations on inflation – banks could easily push up the term structure of interest rates.

Also because if rates were not risen it would have been more difficult to implement trading strategies that could profit from the reduction in interest rates determined by the NCB's purchases.

And after all the rise in interest rates also met the ECB’s desires since at that time about 25% of the Eurozone Govies was displaying negative rates and was no longer eligible for the PSPP by increasing the risk that the program could run out.

It is the first flash crash and, as expected, after the upward jump followed bearish retracements of the interest rate term structure with higher volatility as it happens in an increasingly less liquid market.

Confirmations of this interpretation of the market behaviors arrive in early June with a second flash crash that exhibits the same pattern.

Following these trading schemes within the Eurosystem, banks have earned almost 13 billion euros; a new phenomenon arises: the QE’s brokerage. Within this scheme of course Germany has done the lion’s share thanks to the higher ECB’s capital key and the fact that Bund yields were the lowest of the member states.

The complex architecture of the QE needed to avoid undue transfers between member countries does not seem to be on the right path.

The QE’s brokerage is recapitalizing the banking system leading Eurozone banks' balance sheets to a scheme in which - for all the duration of the PSPP - Govies will be replaced by other Govies.

Meanwhile the ECB decision to delegate the bonds’ purchases to the NCBs continues that process of nationalization of the public and private debts’ risk, which began with the 1 trillion LTROs of late 2011-early 2012.

In fact LTROs started this process through the nationalization of public debt (i.e.: every banking system took care to buy the government bonds of its own country) and the settlement of inter-bank debts recorded on TARGET2.

In short, the ECB once again becomes a gear of this mechanism that adds centrifugal forces within the Eurosystem in which each member country has to undertakes its own risks.

It is perhaps appropriate to review the PSPP rather than waiting for its end (Autumn 2016) when the banks (once recapitalized through the QE’s brokerage) will probably take care of the real economy.

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Bank of Greece expulsion from the Eurosystem could be especially damaging to the currency union

Risks to the euro area's ongoing economic recovery have risen recently as Greece once again takes center stage. The nation is about to become the first developed economy to default on its IMF obligation (joining countries such as Sudan and Iraq). Such outcome may also ultimately result in its exit from the EMU.

Reuters: - Cut off from markets and refusing so far to accept the terms set by its lenders, the Greek government may have to choose in the next few weeks to pay salaries and pensions or repay International Monetary Fund loans.

Its official creditors - the euro zone and the IMF - have frozen bailout aid until the new leftist-led government in Athens reaches agreement on a comprehensive package of reforms.

A deal had been pencilled in for an April 24 meeting of euro zone finance ministers in Riga, but it now seems too ambitious, officials said.

That has raised fears the Greek government will not be able to make its next payments to the IMF, which total some $1 billion over the next month. Missing an IMF payment could mean default and, eventually, an exit from the euro zone.

The fiscal situation in Greece has become untenable, with tax revenue collapsing and government cash position barely sufficient to pay government employees and cover pension obligations through the end of the month.

Reuters: - Greece will need to tap all the remaining cash reserves across its public sector -- a total of 2 billion euros -- to pay civil service wages and pensions at the end of the month, according to finance ministry officials.

Barring a last-ditch deal with its creditors, that is likely to leave no money to repay the International Monetary Fund almost 1 billion euros due in the first half of May, although Greece has said it wants to honor its debt obligations. Athens' scramble for basic funds shows how extreme the financial constraints on Greek Prime Minister Alexis Tsipras have become as he tries to convince skeptical foreign creditors to extend his country new financial aid.

Will we see a last minute compromise? Perhaps. But the Eurogroup is experiencing what many dealmakers would categorize as "deal fatigue" - the motivation to find an emergency solution is no longer there. Moreover, the political climate does not favor a compromise with Greece. While the focus has been on Germany, it is the smaller nations such as Slovenia that have argued vehemently that Greece must comply with the original bailout terms. Slovenia, who struggled through the downturn, cutting pay and shrinking expenditures, views Greece as using the bailout funds for pay increases - and then asking for debt forgiveness. Slovenia's taxpayers whose pensions are considerably lower than those in Greece will not look favorably upon such action.

The Slovenia Times: - Our exposure to Greece is 2.7% of GDP, which was in a year after we had a 8% fall in GDP and when we had to slash pay and economise in all areas."

This is why Slovenia will insist on Greece continuing with the restructuring and continuing to meet its obligations to Slovenia as well as international institutions, [Slovenia's Finance Minister Dušan] Mramor said.

"Given such an exposure Slovenia has toward Greece and such solidarity we provided, Greece has said it plans to raise pensions, raise pay, make employments in the public sector and demand an extra cut it its liabilities to Slovenia, while in Slovenia we are slashing pay and economising in all areas," Mramor said.

With little political will to provide additional financing, what happens after the IMF default by Greece? According to Bank of America, "it would trigger a parallel default to the Eurozone bail-out fund (EFSF) under the legal master agreement, and might force the EFSF to cancel its loan packages and demand immediate repayment. This in turn would trigger a default on Greek government bonds issued under the bail-out accord."

The markets are pricing the probability of default as a near certainty at this point, with credit default swap spreads blowing out.

Greek 5-yr and 1-yr sovereign CDS spreads (source: Barclays Research)

The Greek sovereign debt yield curve has inverted further, with the 2-year yield now above 25%.

It is not at all clear what will happen after the default, but the so-called Grexit becomes increasingly likely. Most analysts now believe that unlike in 2012 the Eurozone will be able to weather this storm due to its better capitalized banks, the ongoing quantitative easing by the ECB (coupled with other measures such as TLTRO), well established bailout mechanism (the ESM), and the OMT backstop facility designed to allow the ECB to support any state that is having liquidity problems. The Eurozone should be able to absorb the losses on some €330bn government exposure to Greek public debt.

French Finance Minister Michel Sapin (via Reuters): - "We have learned to build walls to protect ourselves, to protect the banking system, to protect other countries which could become fragile, if something happens in Greece. So Europe is much stronger. Europe has sheltered itself from turbulence. The danger is for Greece."

However, as discussed before, the nation's divorce from the European Monetary Union will be complex and fraught with more uncertainty than many realize. It's not just about Greece defaulting on on the public debt but also about extracting the Bank of Greece from the Eurosystem. By the time Greece imposes capital controls - which seems increasingly likely - the run on Greek banks will have taken its toll. Deposits have already declined sharply since late last year.

Source: Barclays Research

The Greek banks are replacing these lost deposits with emergency funds (ELA) from the Bank of Greece, who is in turn borrowing from the Eurosystem via TARGET2. With these banks increasingly dependent on central bank support, valuations are collapsing as the need for more bailouts becomes clear. This is especially the case if Greece defaults on its bonds which are widely held by Greek banks.

Greek banks share index

So if the Bank of Greece is borrowing, who is doing the lending? The funds come from the other euro area central banks (via the Eurosystem), particularly the Bundesbank. We can see the increase in this exposure to Greece on Bundesbank's balance sheet. As the Greek citizens are removing funds from their banking system (including taking out bank notes), this balance sheet item at Bundesbank rises further.

Source: the Bundesbank (the latest increase is almost entirely due to Greece)

In a Grexit scenario, as the Bank of Greece is expelled from the Eurosystem, it will default on its TARGET2 obligations. That in turn will force Bundesbank (and other core euro area central banks) to take a write-down. Of course a nation such as Germany should easily absorb such a loss and recapitalize its central bank. But at that point the Germans will surely want to know just how much more of such exposure their central bank holds.

The answer at this point is that nearly 70% of Bundesbank's assets are in TARGET2 claims - a half a trillion euro exposure to periphery nations' central banks. How much support for the EMU will the Germans have once they realize that a large portion of their central bank's assets could be at risk? After Grexit, the TARGET2 exposure will no longer be some abstract concept - the risk levels will become quite real and German politicians and the media will surely drive that point home.

Moreover, as Greece imposes currency controls, depositors in other periphery nations are likely to also begin shifting capital out of their domestic banking system - as they see the writing on the wall. Portugal, Spain, and Italy are particularly vulnerable. Such actions will of course end up increasing TARGET2 imbalances further (as was the case in 2012), putting more of Bundesbank's balance sheet at risk. Contagion could become a major problem again. We already see some early signs, as periphery bond yields rose last week in spite of all the QE buying efforts.

Certainly Grexit related damage can be managed by the national central banks and the European Stability Mechanism. These institutions will be promptly recapitalized. Such actions however will anger citizens of some member states, whose taxpayers' funds will be used to fix the damage caused by Greece. Given the chaos and the political backlash such an outcome will generate, it's unclear when - if at all - confidence in the currency union will be restored. As discussed before (see post), history is not on the Eurozone's side.


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Renewed demand for dollar funding in the Eurozone

In 2011, as the sovereign debt crisis engulfed the Eurozone, the EUR/USD swap basis was deep in the negative territory (see 2011 post). It was caused to a large extent by US money market funds who refused to roll dollar-denominated commercial paper issued by European banks. Just as the Lehman commercial paper exposure turned toxic for money market funds in 2008, so was the Eurozone bank exposure in 2011.

In late 2011, with limited ability to fund dollar assets on their balance sheets and no access to dollar deposits, many Eurozone banks turned to the foreign exchange markets. Given their access to euros (via deposits or loans from the ECB), banks converted euros to dollars and used the basis swap market to hedge their FX exposure. That demand for EUR/USD swaps pushed the basis into negative territory. The ECB's currency swap with the Fed alleviated some of the stress by allowing the ECB to lend dollars directly to the euro area banks.

Now the EUR/USD basis swap has turned negative again and some have suggested that the funding pressure on Eurozone banks is back.

Source: @acemaxx, Morgan Stanley

But that's not at all the case. The culprit this time around is the areas demand for yield. Eurozone banks can now access euros at negative rates (chart below) and are willing to pay up on the basis swap to obtain dollar funding - in order to access better yielding dollar assets (USD bonds and loans).

Source: MMI

Moreover, higher-rated US corporations have been actively issuing euro-denominated bonds this year as the demand for quality bonds spikes in response to ECB's QE. These US firms then convert the proceeds from the bond sales to dollars in order to fund US operations. But since they will need to repay euros in the future, they hedge themselves with EUR/USD basis swaps. That puts further downward pressure on the basis.

Demand for dollar funding in the Eurozone is likely to remain elevated, as the area provides extraordinarily cheap financing while access to quality fixed income product has become increasingly limited.

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The Eurozone: on the road to recovery with a lingering risk

Posted by Walter

Back in September the idea that the Eurozone's economy could potentially undergo a recovery (see post) was met with some skepticism. And yet here we are. The EuroStoxx50 index is up 14% for the year while the Dow is up 2.5%. We now see plenty of indicators showing strengthening economy in the euro area.

To begin with, the area's credit conditions continue to improve as loan growth is about to turn positive for the first time since the middle of 2012.

Source: ECB, Investing.com

Corporate and household loan expansion, while still terrible relative to the US, is on the right path. This is particularly true after the conclusion of the ECB's stress tests (which were a major source of uncertainty in 2013).

Source: ECB

The area's bank deleveraging is ending (see post) and the strongest evidence of that can be seen in the acceleration of the broad money supply growth. The M3 expansion trend has been fairly consistently beating economists' forecasts.

Source: ECB/

Both business and consumer sentiment surveys, which soured significantly after the Russia sanctions went into effect, showed marked improvements recently. Part of the reason is the decline in fuel prices.

Source: TradingEconomics

Source: Investing.com

Moreover, the labor markets are exhibiting signs of stabilization. Just to be clear, the declining unemployment is highly uneven across the various states and nobody claims the job situation in the Eurozone is in good shape.

By any measure, the job markets in some of the periphery nations are dreadful. But on a relative basis, hiring across the euro area has been improving.

RBS: - Baby steps. The Spanish labour market has enjoyed its best year since 2007 - a start on a 23.4% unemployment rate.

Source: RBS

A number of these surprises to the upside are reflected in the Citi Economic Surprise Index, which shows the Eurozone diverging from the US.

Source: ‏ @sobata416, @valuewalk, @HedgeLy 

Going forward, the sharp deterioration of the euro and the ECB's expected massive bond buying program should halt deflationary pressures (although just as the case in Japan, inflation is likely to remain below the ECB's target for a while). Weaker euro may also help the area's exporters.

Source: Investing.com

But the euro area's economy is not out of the woods yet. The greatest and the most immediate risk to the recovery remains the developments in Greece. While the Eurogroup has kicked the can down the road, the situation could deteriorate quickly even before the bridge financing matures. Depositors are continuing to withdraw money out of Greek banks.

Source: @Schuldensuehner

Nobody wants to get caught with a Cyprus type situation where people's property was confiscated by the state via deposit haircuts. An even worse scenario would be having deposits forcibly converted into drachmas that will find no bid in the FX market. The Greek government is already taunting the Eurogroup with creative drachma notes designs (Greece will need take lessons from Zimbabwe and add a few zeros to some of these notes).

Source: @AmbroseEP

As these deposits leave, Greek banks lose their limited sources of private funding and increasingly rely on the Bank of Greece for the emergency liquidity assistance (ELA) loans. In fact investors have little confidence that the banks are sufficiently capitalized after the last bailout to withstand this transition. That's why today alone, the banking sector took a 10% hit.

Why does this relatively small nation present such a risk to the Eurozone's nascent recovery? The ELA loans are financed via Target2 as the Bank of Greece borrows from the Eurosystem. In a Grexit scenario the Bank of Greece will be unable (or unwilling) to repay these loans, forcing the Eurosystem (the ECB) to take a significant hit.

There is no question that the EMU will easily withstand such an event - it's not a great sum of money in the larger scheme of things. But the loss of confidence and the political nightmare associated with recapitalizing the ECB as well as the fears of contagion to other periphery nations may send the euro area back into recession. Will depositors in Italy, Portugal, and Spain begin to move their deposits out as well in order to avoid being "drachmatized"? Economists often forger, it's less about the specific euro amounts and more about the psychology of fear.

If however the Eurogroup manages to somehow stabilize the Greek situation, a steady economic recovery could be in store for the Eurozone. The next few months will be crucial.

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