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Europe's Q€ Currency War

The Eurozone is fighting Japan by exporting its deflation problem to Switzerland...
 
The THEATER of the absurd became even more bizarre on Jan 22nd, when the European Central bank – desperate to extricate the Eurozone's economy from the quagmire of deflation and stagnation – decided it would try its hand at the magic elixir of "quantitative easing", or Q€, writes Gary Dorsch, editor of the Global Money Trends newsletter.
 
Starting on March 1st, the ECB will inject €60 billion of liquidity into the Eurozone's money markets, each month until the end of Sept 2016. The ECB is the last of the Big-4 central banks to unleash the nuclear option of central banking – QE – starting about six years after the Bank of England, the Bank of Japan, and the Fed began flooding the world markets with $7 trillion of British Pounds, Japanese Yen and US Dollars.
 
Proponents of QE argue that the UK and US economies are among the best performing in the developed world today, and the massive doses of money printing and near zero interest rate policies (ZIRP) are the main reasons why.
 
Opponents of QE say the liquidity injections are mostly channeled into the bond and stock markets – enriching the owners of financial assets, and very little of the QE-injections "trickle down" into the hands of the struggling masses.
 
Instead, thanks to QE and ZIRP, the net worth of the world's 400 wealthiest has mushroomed to a cumulative $4.1 trillion. The Richest 85 billionaires now control more wealth than half of the world's population combined, or 3.5 billion persons.
 
Many of the world's ultra-wealthy were in attendance at the World Economic Forum in Davos, Switzerland last month, dining and conversing with the most powerful central bankers and finance ministers from around the world, and getting a few "hot tips". Also in attendance, was the Bank of Japan chief Haruhiko Kuroda who welcomed the prospect of the upcoming "Tug-of-War" with the ECB over the direction of the Euro/Yen exchange rate.
 
"We very much welcome this QE action by the ECB," Kuroda said in Davos. "The decision could end deflationary pressures and stimulate growth in Europe, which is good for the economies of Japan and the world."
 
 
However, when translating Kuroda's jargon into plain English, what he really said to investors was:
"The ECB's decision could end deflationary pressures (ie, reduce selling pressure in the Eurozone stock markets) and stimulate growth in Europe (ie, inflate EuroStoxx valuations and P/E multiples), which is good for Japan (ie, owners of Tokyo-listed equities) and the world (ie, the Richest 1%)."
On October 31st last year – the same day the US Fed mothballed its QE-3 scheme – the Bank of Japan jolted the world stock markets sharply higher when it stated its intention to buy ¥80 trillion of Japanese government bonds over the next 12 months, which means the BoJ would soak up all of the new bonds that the Ministry of Finance sells.
 
The BoJ already holds about 20% of Japan's outstanding government bonds,and if it continues to underwrite the entire deficits of the government, it could end up owning half of the JGB market by as early as in 2018. BoJ chief Kuroda says the massive printing of Yen – dubbed "QQE" in Japan – is necessary to prevent a reversal into a "deflationary mindset" that has stymied Japan's economy for decades.
"Countering such a trend is the most important thing we can do. Whatever we can do, we will," Kuroda said.
Reading between the lines, the "deflationary mindset" that Kuroda aims to turn around is the bearish psychology that has plagued the Tokyo Stock Exchange for more than two decades.
 
Since the BoJ unleashed QQE in Dec '13, the Nikkei 225 stock index has doubled in value to above 17,500 points thanks to a 50% devaluation of the Japanese Yen versus the US Dollar.
 
Meantime in the Eurozone, for almost two years inflation has been consistently below the ECB's target rate of 2% per annum, with each month showing a lower figure than the previous one. More than six years after the collapse of Lehman Brothers and the start of the "Great Recession", conditions are still at Depression-like levels in the peripheral countries of Europe, with double-digit unemployment rates, and ever-lower living standards and rising poverty that have become a permanent situation.
 
Reflecting the deeply entrenched trend of deflation, the yield on Germany's 5-year Schatz turned negative on January 15th, falling as low as minus 5-basis points before rebounding to +1-bps.
 
As such, the ECB unveiled its most aggressive effort to date to revive the region's ailing economy (ie, inflate the EuroStoxx index) with a Q€ scheme to print €1.1 trillion and purchase government and private bonds starting in March.
 
Thus, the BoJ and ECB will engage in hand to hand combat over the Euro/Yen exchange rate in the year ahead. Initially, the BoJ gained the upper hand because it struck first with a surprise attack by expanding its QQE scheme to ¥80 trillion per year. That act of "shock and awe" lifted the Euro as high as ¥150 in December.
 
However, the ECB quickly retaliated by driving German T-bill rates to zero percent, some minus 16-bps below Japanese T-bill rates. And of course, the ECB has upped the ante, by playing the Q€1.1 trillion card, and in turn, knocked the Euro sharply lower to ¥130 last week.
 
German firms are going head-to-head with Japanese firms in the $3.4 trillion capital goods export market. Together, their two heavy weight central banks are planning to inject a combined ¥10 trillion and €720 billion into the world money markets over one year's time. But there is no quick fix.
 
 
On January 15th, the Swiss National Bank shocked the markets in one of the most memorable days in the history of currency trading.
 
The SNB swept the rug from under the feet of currency, debt, and equity traders alike, when it decided to abandon its defense of the Euro versus the Swiss Franc. The SNB's sudden withdrawal from the currency wars sent the Swiss Franc soaring by 20% within a few minutes, a move that rippled through global markets and wiped CHF155 billion off the value of the Swiss stock market.
 
The SNB scrapped its defense of the Euro at 1.20 per Swiss Franc just days after SNB officials said the currency peg was absolutely necessary to fend off deflation and a recession. SNB deputy Jean-Pierre Danthine said on Jan 12th that the CHF1.20 floor for the Euro would remain a "pillar" of monetary policy.
"We took stock of the situation less than a month ago, we looked again at all the parameters and we are convinced that the minimum exchange rate must remain the cornerstone of our monetary policy," Danthine declared.
Earlier, on Jan 5th, SNB chief Thomas Jordan said the currency peg as "absolutely central". And since introducing the currency peg in Sept 2011, the SNB had printed roughly CHF400 billion and used it to buy Euros and US Dollars.
 
As of Jan 14th, the SNB's foreign currency reserve had increased to a record CHF495 billion, equal to 85% of Switzerland's GDP. Then, the gig was up. The SNB realized it was not possible to match the ECB's forthcoming €1.1 trillion Q€-printing spree. To counter the ECB, the SNB would have to print Swiss Francs equal to 2-times the size of Switzerland's annual GDP.
 
In Zurich, the SNB's defense of the currency peg had in essence become a quasi QE-scheme. Much of the 400 billion of Swiss Francs that were injected into the foreign currency market filtered into Swiss bonds (pushing the Swiss 10-year yield below zero percent) and into blue-chip Swiss stocks. However, when the SNB suddenly went cold turkey on quasi-QE, and abandoned the Euro/Franc peg, it triggered an instant reaction of panic.
 
The Swiss Market Index (SMI) tumbled 15% lower, and its two-day crash was the biggest since "Black Monday" in October 1987, wiping out around CHF155 billion in market value.
 
Morgan Stanley analysts wrote:
"We estimate that 85% of SMI sales come from overseas, and many of the large-cap names generate 90-95% of their revenues from sales outside Switzerland. With the Franc worth around 17% more than it was a day and a half ago – the Franc is now nearly at parity with the Euro – Swiss companies must face the challenge of absorbing what amounts to a 17% reduction in revenue on every item sold in the Eurozone."
The SNB's retreat from quasi-QE also has far reaching consequences for 550,000 Poles, 150,000 Romanians, and many Croatians who have mortgage debts denominated in Swiss Francs, and now face 17% increases in their interest and principal payments.
 
However, on Jan 18th, Switzerland's finance chief Eveline Widmer-Schlumpfsought to reassure shell shocked investors that abandoning the currency peg with the Euro would not destabilize the Swiss economy. She predicted the Euro would eventually rebound to CHF1.10...
"I'm confident that the economy will be able to cope with this decision. Companies are in a far better position than in 2011 when the cap was introduced."
Sure enough, on Jan 27th, the SNB backed-up the finance chief, and issued a warning that it is ready to intervene in the currency market to support the Euro against the Swiss Franc. "Giving up the cap means a tightening of monetary policy. We accept this, but only up to a point. We are fundamentally prepared to intervene in the foreign exchange market," warned SNB deputy Jean-Pierre Danthine. He said it would take some time for the foreign exchange markets to balance out, and declined to give exact levels, the SNB is aiming for the Swiss Franc versus the Euro and the US Dollar.
 
Already, signs of stability in the Euro's value at around parity with the Swiss Franc was enough of a signal for bargain hunters to pick-up battered Swiss shares. With the SNB alerting traders that it is not completely walking away from currency intervention, traders bid-up the SMI 5% higher to the 8,400 level on Jan 27th.
 
In turn, signs of stability for the Euro/Franc led speculators to dump Swiss T-bills. The yield on Switzerland's 3-month T-bill jumped to minus 118-bps on Jan 27th, from a record low of minus 260-bps on Jan 23rd.
 
 
Still, the Swiss economy will have to deal with a "deflationary" shock, largely as a result of the ECB's decision to launch Q€. The SNB might have to widen the scope of bank deposits that are affected by negative rates in order to weaken the Swiss Franc, and unwind the deflationary pressures.
 
The Swiss consumer price index fell -0.5% in December, and compared with Dec '13 the CPI was -0.3% lower against annualized rates of -0.1% in Nov '14. In light of the Swiss Franc's rapid appreciation against the US Dollar to around $1.100, the Continuous Commodity Index – a basket of 17-equally weighted commodities – is trading 16% lower compared with a year ago when measured in the Swiss Franc.
 
In turn, that could keep the Swiss CPI in negative territory in the months ahead. And the ability of the SNB to support the Euro/Franc with sporadic rounds of interventions would be limited at best, given the expected flow of €1.1 trillion from the ECBs printing press thru Sept '16.
 
In essence, the ECB is exporting the Eurozone's deflation problem to Switzerland. Still, the ECB's belated Q€ scheme cannot disguise the fact that the Eurozone economy is based upon a one-size-fits-all monetary policy that is fatally flawed.
 
The economic divergence between Europe's wealthy core countries and the weaker debt-saddled periphery continues to widen. On the fiscal side, Berlin has insisted instead that the big debtors in the Eurozone push through painful spending cuts and tax increases to reduce their budget deficits, in line with its own successful fiscal model. The Irish, Spanish, Italian, and Portuguese are going along with these policies for now, but skeptics worry that in the years to come this strategy will be exposed as deeply flawed and result in long lasting stagnation and high levels of joblessness.
 
Support for political fringe parties that want to break-away from fiscal austerity, such as in Greece, is also leading a growing numbers of citizens to conclude, that they might be better off outside the currency union.
 
And who says interest rates can't go below zero-percent? While end-January's news centered on the fall in US 10-year Treasury yields as low as 1.75%, the bigger news is Germany's 5-year Schatz trading at zero-percent returns.
 
Why would anybody lock in a yield of zero-percent for 5 years? Perhaps it's a low cost "option play" – betting on the eventual break-up of the Euro currency.
 
Although the Deutsche Mark is officially out of circulation, in the event that the Euro does break up into the former currencies of each member state, then it would be a logical assumption that all securities would also be redenominated in those original currencies.
 
So German Bunds would be denominated in the Deutsche Mark. That is one reason why the 5-year Schatz is yielding zero percent. And while the investor that buys German T-bills or notes at less than zero-percent effectively pays interest to Berlin, the expected pay-off from big currency gains – due to the potential break-up of the Euro – would far exceed the costs.
 
In that "Black Swan" scenario, the currencies of the periphery – new Drachma, New Escudo, New Peseta and new Irish Punt – could be revalued far below the new Deutsche Mark.
 
It's difficult to pinpoint exactly the reason for negative interest rates in Germany, although it certainly deserves the lowest borrowing costs in the Eurozone. Germany balanced its federal budget for the first time in almost half a century in 2014, and even managed to pay off old debts worth €2.5 billion.
 
Germany's finance chief Wolfgang Schaeuble says Berlin won't issue new debt in 2015 and is aiming to generate a budget surplus in 2016, helped by soaring tax revenues and record-low unemployment – plus those negative interest rates resulting from its safe-haven status. Outside of Germany, however, there are 26 million people unemployed in the EU, including around one in every two young people in Greece, Spain and parts of Italy and Portugal.
 
Another possible reason for the emergence of negative interest rates in Germany is the possibility of a massive short squeeze in the German Bund market once the ECB begins to buy sovereign bonds.
 
The amount of eligible Euro-area government bonds is €7 trillion and the estimated net government bond issuance is around €90 billion in the year ahead. If correct, the ECB would soak-up around 55% of the newly issued debts, reducing the amount of German Bunds in circulation with Berlin running a balanced fiscal budget or even a small surplus. Around €1.4 trillion of Euro-area government bonds are already trading with negative nominal yields, almost all of them up to 5-years maturity.
 
 
Whatever the reason for the emergence of negative interest rates in Europe, it's suddenly made the gold market more attractive, simply because the yellow metal is yielding a higher rate of interest, albeit zero percent. And with the ECB vowing to further dilute the value of the Euro against other paper currencies through its Q€ scheme, there has been a panicked flight from the Euro and into safer havens.
 
The immediate news that might explain gold's sudden explosive 15% rally against the Euro in the month of January '15, reaching as high as €1,150 per ounce, is Greece. Most traders to date have concluded that the cost of Greece exiting the Euro currency union is so high that Athens would not contemplate it. However, the virtual economic collapse and high poverty level in Greece that has led the left-wing Syriza opposition party led by Alexis Tsiprasto to power have upset those calculations. Greece, in effect, has a lot less to lose by leaving the Euro currency.
 
Greece's economy has shrunk by 25% since the onset of the "Great Recession". Thousands of businesses have closed, wages and pensions have been slashed and more than half of young people are unemployed. Half a million citizens have left the country.
 
At the same time, its massive public debt has climbed to €320 billion, or 176% of GDP last year, the second highest in the world. Greece could declare bankruptcy if a solution is not found. As such, there is a flight from Greek bonds that has already doubled the yield on Greece's 10-year note since the start of September to as high as 10.70% this week.
 
Yet Berlin believes that the rest of the Eurozone would be able to cope with a Greece exit if that proved to be necessary, Der Spiegel magazine reported on Jan 3rd. Both German chancellor Angela Merkel and finance chief Wolfgang Schaeuble believe that:
"...the danger of contagion is limited because Portugal and Ireland are considered rehabilitated. In addition, the European Stability Mechanism (ESM), the Eurozone's bailout fund, is an effective rescue mechanism and is now available."
According to the report, the German government considers a Greece exit almost unavoidable if the left-wing Syriza opposition party led by Alexis Tsiprasto tries to cancel austerity measures and a chunk of Greek debt.
"If Alexis Tsipras of the Greek left party Syriza thinks he can cut back the reform efforts and austerity measures, then the troika will have to cut back the credits for Greece, " warned Merkel's chief advisor Michael Fuchson January 3rd. "The times where we had to rescue Greece are over. There is no potential for political blackmail anymore. Greece is no longer of systemic importance for the Euro."
On the other hand, many traders are bidding up the price of gold and German Bunds, fearful that a Grexit could open the way for the eventual demise of the Euro and a return to the Deutsche Mark.

GARY DORSCH is editor of the Global Money Trends newsletter. He worked as chief financial futures analyst for three clearing firms on the trading floor of the Chicago Mercantile Exchange before moving to the US and foreign equities trading desk of Charles Schwab and Co.

There he traded across 45 different exchanges, including Australia, Canada, Japan, Hong Kong, the Eurozone, London, Toronto, South Africa, Mexico and New Zealand. With extensive experience of forex, US high grade and corporate junk bonds, foreign government bonds, gold stocks, ADRs, a wide range of US equities and options as well as Canadian oil trusts, he wrote from 2000 to Sept. '05 a weekly newsletter, Foreign Currency Trends, for Charles Schwab's Global Investment department.

See the full archive of Gary Dorsch.

 

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