Over the past few weeks the Euro has formed a triple bottom at 1.3450 against the Dollar (the lows were on 19 Feb, 25 Feb and 2 Mar 2010).  Triple bottoms are rare in markets because most times a market prints a bottom, bounces off that bottom the first time it is tested but breaks through the support level if it is tested again (hence the old trading adage “Fade the first test but Go With the second test”).

The Euro now appears to have absorbed the selling pressure which has resulted from the problems Greece has been having in refinancing its borrowings.  Whilst the EU has pledged not to abandon Greece it has still not given any firm details on how it plans to offer support to Greece other than to encourage Greece to reduce its budget deficit towards 3% of GDP (as per the euro-zone’s Growth & Stability Pact).  Greece for its part “would like to borrow on the same terms” as other euro-zone members.  However the bond markets will demand a substantial premium to lend money to Greece until it proves it is actually carrying out the deficit-reduction measures it has promised in recent weeks. Yesterday Greece sold a €5 bln 10-year bond with a coupon of 6.25%, yielding roughly 312 bps over Bunds.

It has also become clearer over recent weeks that any support extended to Greece by the EU will not formally involve the ECB printing any money.  Euro-zone member governments have met public opposition to bailing out Greece with taxpayers’ money and the German press in particular has run stories opposing bailing out Greece if it means Greek public sector workers can still retire earlier than their German equivalents or even suggesting Greece sell off some of its uninhabited islands to raise some money.  Greece has in turn demanded the Germans return Greek gold which the Nazis allegedly stole during World War II…

Back to reality.  The receding prospect of the ECB printing money has helped the Euro to find support over recent weeks.  There is a subtle difference between the ECB printing money in order to buy Greek bonds and other euro-zone banks buying Greek bonds yielding circa 6% (with a strong nudge and guarantees from their respective governments) which they then use as collateral to borrow money from the ECB (at 1%).  The latter is simply good banking even if the net effect either way is the ECB finances loaning Greece money.  In the latter case the ECB can correctly claim that the risk lies not with it but with the banks.

Now that the Euro has found support at 1.3450 (until the market proves us wrong), the forex market can switch its attention to giving the Pound Sterling a good kicking in the run up to the May General Election.

UK politicians have started the new year with their eyes firmly focused on the upcoming General Election, which will most probably be held in May.  This week’s Hoon-Hewitt challenge on Gordon Brown’s leadership has only served to increase the uncertainty surrounding the result of the General Election.

Markets hate nothing more than uncertainty and although the Conservatives are tipped to win this year’s election there is the distinct possibility of the result being a hung parliament.  In such an eventuality the correct course of action for David Cameron would be to call another immediate snap election, seeking a clear mandate from the British public.  However, politicians enter politics in order to gain power so do not expect him to risk losing his grip on power (however slender) by risking another election.  The only upside of a hung parliament would be that the very competent Vince Cable would become a Cabinet minister.

What the Gilts market (in particular) needs from this election is a clear mandate for one party to go ahead and tackle the UK budget deficit in a decisive manner for the duration of the next parliament.  With 10-year Gilts now yielding 4% and Base Rates stuck at 0.5% until at least the other side of a post-election budget (and likely a lot longer if spending cuts & tax rises are sketched out in the post-election budget – as they should be), a sharp sell-off in the Gilts market ahead of the election is not likely so the pressure will be felt most in the currency markets.  Sterling depreciating will be beneficial to the stock market as a result of translating overseas earnings and a lower currency making UK assets cheaper to foreign buyers (retailers who source their product from overseas, as well as relying on UK consumers who will likely be squeezed by a post-election budget, would miss out on this particular party).

Uncertainties about an indecisive hung parliament are likely to surface first in the currency markets and we can expect Sterling to wobble seriously ahead of the General Election.  The Bank of England is unlikely to worry too much about a further slide in Sterling unless it becomes disorderly (as the UK economy, which is still officially in recession, will benefit from cheaper Sterling), so expect parity to be tested against the Euro, although it is doubtful Sterling will stay below parity for very long.

Do the last three weeks of US Dollar strength represent the start of a bigger upswing in the fortunes of the Dollar?

We have just seen the Dollar close higher for three consecutive weeks, as measured by the Dollar Index. This hasn’t happened since the Dollar topped out in March 2009 (as global stockmarkets simultaneously bottomed).  We last saw a strong Dollar rally during July – November 2008 as a mad scramble for dollars took place – see “Get me a Printing Press“.

There is also a confluence of fundamental factors coming together at the moment which together provide a more solid basis for a sustainable rally in the Dollar.  The Fed is scheduled to end its current bout of $1.75 trillion QE bond purchases by the end of Q1 2010.  In addition this week’s FOMC statement highlighted that most of the Fed’s special liquidity facilities will expire on 1 Feb 2010 and that the Fed will also be closing its Dollar swap arrangements with other central banks by 1 Feb 2010 too.  The net effect is that the Fed will be shutting down three different ways in which it has been supplying Dollars to the markets.

For its part, the Euro has been impacted by the recent turmoil seen in Greece’s government bond markets and the currency markets have once again taken note that the Euro is not the same thing as a Deutschmark and it can be undermined to a certain extent by the PIIGS membership.  If Greece really got into trouble, there is no way that the other, more stable, members of the Euro would allow Greece to be rescued by the IMF (and thereby show to the whole world that Euro-land couldn’t manage its own internal affairs).

The Japanese Central Bank is also offering 10 trillion Yen in 90-day money into its money market, although the Japanese have historically been quite timid with their Quantitative Easing and this measure runs true to form in being less aggressive than, say, purchasing long-term government bonds.

Finally the US employment report for November 2009 showed both the unemployment rate falling and weekly hours worked rising.  This implies stronger US GDP (70% of which is consumer spending) which has also served to boost the Dollar.

Neither is the Fed itself going to stand in the way of a Dollar rally.  Now that a tentative recovery has been established in the States and GDP is growing again, the Fed does not need to manage the Dollar lower from here but it would surely be happy to see a combination of the Dollar rallying and lower oil prices (which would serve to keep inflation under control and lower gasoline prices would put more money into consumers pockets).

A Dollar rally at this stage is not negative for US stockmarkets because consumers having more money to spend means that companies can grow their top-line sales and generate higher profits.  These higher profits will help to keep the stockmarket rallying into 2010 (the Dow has been in a 10,200-10,500 range for the last 5 weeks, consolidating now that it has recovered half of its Oct 2007 – March 2009 losses).

The Bank of England continues to do its best to debase Sterling by printing as much money as possible without scaring the gilts market.  The only reason Sterling hasn’t collapsed against other currencies is that the other major central banks are all involved in various forms of printing money (quantitative easing) themselves.  Sterling is however steadily weakening against the Euro as the ECB is the only major central bank not currently printing money freely (see Vee are Not Embarking on QE).

But the BoE has shown it means business by recently increasing the amount of money it is planning to print from £125 bln to £175 bln and the Governor letting it be known that there is more money where this came from as he would rather print £200 bln.  The Governor is doing his best to stay ahead of the likely £175bln-plus of gilts to be issued this year.  However so far the QE money spent by the BoE has ended up mostly in commercial bank reserve deposits back at the Bank of England (a telling indication of just how much cash the banks now have is that 3-month Sterling Libor at 47bps is now below the Bank Rate for the first time since the credit crisis broke in the summer of 2007).  The challenge is how to get this money injected into the real economy given that households and corporates don’t want to borrow and companies are preferring to launch rights issues to fund their acquisitions with equity rather than debt (and the REITs are busy selling new shares to pay down their debts too). 

The BoE have hinted that the next trick they will try in their attempt to move the money currently held by the banks at the BoE is to stop paying interest on this money.  Given that the Bank Rate is only 50bps then reducing it to zero may not be a big enough incentive and the banks may well just shift the money into the very short end of the gilt market.  However not paying interest on commercial bank reserves will come in very handy when the time eventually comes for the BoE to start raising interest rates again, so we can expect this policy move to happen at some stage.  The more drastic step of paying a negative interest rate on commercial bank reserves (by charging the banks interest to deposit money at the BoE) will achieve nothing as the logical response from the banks would be the same – shift the money into short-term gilts.

With everyone looking to raise equity and retire debt, getting the QE money into the real economy may take a quite a while longer to work (there is no history to refer back to here as the Japanese were too timid when they tried QE).  In the meantime the BoE has little option other than to carry on printing money until a sustainable economic recovery takes hold.  Expect Sterling to continue to depreciate against real assets and harder currencies such as the Euro.

A recession can be viewed as too little demand for goods & services (nominal GDP). One way for a country to bring itself out of recession is to depreciate its currency (which effectively moves GDP, via exports, to the country in recession from other countries, boosting the former’s GDP). However the problem with the current global recession is that this is not an option as there is too little demand for goods & services across the globe. A country cannot just devalue itself out of a global recession. Japan has just given us an excellent example of what happens when a country is too reliant on exports, as demand has contracted globally, Japanese exports have just fallen off a cliff (down nearly 50%) and Japanese GDP has contracted as a result (when the world finally recovers from this global recession both Germany & Japan are likely to try to grow the size of their domestic economies so as not to fall into this trap again). What is needed is for the global pie of nominal GDP to be expanded.
Welcome to Worldwide Quantitative Easing. If every major economy stimulates its own nominal GDP by convincing their independent central banks to print money and spend it by purchasing government bonds (the governments then spend the borrowed money on goods & services) then the result will be the desired expansion of the global pie of nominal GDP. The side effect is a round of currency devaluations which show up most noticeably against any country which doesn’t engage in QE (the Euro is leading this particular pack and the usually-conservative Swiss recently decided they did not want their currency to appreciate alongside the Euro so they intervened to lower the Swiss Franc against the Euro and embarked upon Quantitative Easing of their own to boost their GDP and underline to the FX market that they meant business). Also, as mentioned in Race to the Bottom (27 March 2009), real assets increase in value (as measured in fiat currencies) - admittedly real estate & equities are currently in bear markets but they won’t last forever, especially at this rate.
The question of whether the world’s central banks are capable creating just enough inflation but not too much can be left for a while.  The central banks will have to err on the side of creating too much inflation in order to be on the safe side – then they can rein inflation back in again by slowly taking the punch bowl away so as not to undermine the recovery.

All this currency printing (Dollars, Sterling, Yen & Swiss Francs) by central banks as they engage in their various forms of quantitative easing is leading to a depreciation of their currencies against real assets. This is being disguised by talk of currencies engaging in competitive devaluations against one another but eventually it will show up in the price of real assets increasing as measured against these fiat currencies. By real assets we are talking about Oil, Real Estate, Gold and Equities (the first three of which God ain’t making any more & equities are a claim on nominal GDP). Government bonds are being propped up by heavy central bank buying and may well remain expensive for years (there is no point in fighting concerted central bank buying of government bonds – John Maynard Keynes pointed out that “markets can stay irrational for longer than speculators can stay solvent”). Don’t read too much into “failed auctions” of Government bonds such as happened this week in Gilts – this is a brave new world and market participants are still feeling their way towards what they should be paying the DMO for 40-year gilts when the BoE is busy buying 5- to 20-year paper. The head of the DMO (whose job it is to sell gilts as expensively as possible) should have kept quiet rather than allow himself to be quoted as saying “Yields at these levels are not all that attractive”. However the general idea to issue longer-dated gilts than the BoE is buying back is surely the correct strategy for the DMO to execute whilst gilt yields are this low, even if the execution is proving a little untidy at times.
As usual the ECB is the slowest of the Western central banks to act – they have yet to commence quantitative easing but the central bankers of Portugal, Ireland, Italy, Greece & Spain (collectively called the PIIGS) must be praying for the ECB to start buying government bonds soon as there are few other buyers of PIIGS bonds at the moment and they have lots to sell. The ECB has a practical problem to overcome if & when it decides to implement quantitative easing, namely which eurozone countries does it choose to favour by buying their government bonds? If the ECB wishes to ease tight credit conditions then it should logically buy the PIIGS’ bonds and squeeze their yields back down towards German levels (the great “convergence trade” would be back on with a vengence), in the process helping to allay market fears about any of the PIIGS leaving the Euro. Once could reasonably expect squealing from any eurozone country whose bonds were not purchased by the ECB. Not a pretty problem for the ECB to overcome whilst other central banks already have the printing presses rolling flat out.

Post-Script (23 April 2009) :  One possible way for the ECB to execute Quantitative Easing would be for the ECB to spend its money by buying equal amounts of each eurozone member countries’ government bonds.  In this way the policy could be sold as being “fair” to all whilst having the desired side-effect of a greater impact on the PIIGS due to the smaller size of their economies relative to Germany, France, et al.