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.

Last Thursday the Fed raised its discount rate by 25 bps to 0.75%, as highlighted 8 days previously in Bernanke’s Exit Strategy speech on 10 Feb 2010.  As a result it now stands 50 bps above the upper limit of the current 0% – 0.25% range for the Fed Funds rate.  The Fed also took the opportunity to announce the return to the usual 1-day time limit for banks borrowing at the discount window (down from 30 days which was first put in place on 17 August 2007 - as the credit crunch first started to bite).  These actions indicate that the Fed is confident that the banks have now got their funding arrangements back into good order.

Despite the FT’s Lex column (20 Feb 2010) claiming that the discount rate is “almost irrelevant these days”, the Fed’s discount rate will become very important when the Fed eventually begins its next rate tightening cycle.  This is because the discount rate effectively represents the upper bound of the overnight interest rate during the period when the Fed is steadily raising rates.  The market doesn’t care about the lower boundary for overnight interest rates when rates are trending higher.

The Fed has also taken the precaution of giving itself the option of paying interest on money that US banks have placed on deposit at the 12 Federal Reserve Banks ($1.1 trillion is currently sitting on deposit).  In this way the Fed can force market interest rates higher should it prove difficult to get the Fed Funds rate moving in the desired direction (because of the $1.725 trillion which the Fed has thus far supplied to the markets via its Quantitative Easing efforts).

However any actual rise in US interest rates is still over the horizon and well out of sight.  The Fed has a so-called dual mandate to both contain inflation and promote employment (unlike the ECB which is only tasked with keeping inflation under control).  US unemployment is still very high at 9.7%  and, counter-intuitively, the unemployment rate may well rise further as a strengthening economy creates jobs.  Bernanke said in testimony this week that low interest rates “are supporting a nascent economic recovery”  and that “although the federal funds rate is likely to remain exceptionally low for an extended period, as the expansion matures, the Federal Reserve will at some point need to begin to tighten monetary conditions to prevent the development of inflationary pressures”.  In plain English, the Fed is going to wait and let the economy grow and create lots of jobs before risking its first rate rise. 

The Fed is simply getting its ducks in a row by preparing the ground for an eventual rate raising cycle.  It has to raise the discount rate first in order to create some additional headroom above the Fed Funds rate which it can then rise into.  By raising the discount rate well in advance of any hike in the Fed Funds rate, the Fed can now sit back and watch the market’s reaction, paying particular attention to 3-month Dollar Libor (the rate at which banks borrow Dollars from each other for a period of 3 months), which has been trading around 26 bps for many weeks now.

The Fed would like banks to borrow from each other and ideally to obtain funds from depositors rather than directly from the Fed itself at the discount window.  Historically the discount rate has been kept 100 bps above the Fed Funds rate and we can expect the Fed to aim for this level in future months.

The Euro continues to trend lower against the Dollar as the recent turmoil in Greece’s government bond markets has started to spread to Portugal and Spain too.  Events are starting to spiral out of control, evidenced by 10-year Greek bond yields rising from below 6% to more than 7% over the past few weeks (inflicting losses on the buyers of Greece’s €8 bln 6.2% 2015 bond which was issued on 25th Jan 2010).

Eight billion euros is only the first instalment on the €53 bln which Greece needs to raise in 2010 and it is this impending refinancing need which will bring matters to a head sooner rather then later.  Greece is now in the market’s spotlight and is really in trouble because this particular bond market storm is not going to simply blow itself out and go away.

The panic in Greece’s bond market is going to have to get a whole lot worse and this will eventually force the rest of the Euro-zone to act.  The markets don’t believe that the Greek government will be able to impose austerity measures on the Greek public (public demonstrations and strikes have already started).  ECB President Trichet has been quoted as saying ”We expect and we are confident that the Greek government will take all the decisions that will permit them to reach their goal”.  What else can he say?  If he told the truth and said they were stuck like pigs in a poke and the squealing would have to get a whole lot louder before they get bailed out, then Greece’s bond market collapse would intensify and yields would rise even more rapidly.

The endgame is fast approaching and it will not include the IMF lending money.  The bigger and more stable members of the Euro cannot allow Greece to be rescued by the IMF and thereby show the whole world that Euro-land can’t manage its own internal affairs.  Whatever tax-raising promises get made by the Greek government are irrelevant (as only time will tell whether they can actually impose the promised tax rises on the Greek public) as Greece does not have the luxury of time on its side.  

The end of this crisis will be signalled by a large amount of money being loaned to Greece by any or all of the following : Germany, France and the ECB.  Watch out for a classic euro-zone “enhanced credit support” fudge whereby the ECB suddenly decides to embark upon Quantitative Easing which involves the purchase of large quantities of euro-zone members’ government bonds.  The EU itself cannot extend a long-term loan because it also represents non-eurozone members.

Markets are going to become even more disorderly before this panic is over but the bigger picture is that this is a panic in the PIIGS’ government bond markets and, whilst it may impact other markets in the short-term, the resolution of the crisis will provide a buying opportunity across multiple asset classes.  The Euro will keep trending lower against the Dollar (and Sterling to a lesser extent) until the crisis is resolved because the resolution may involve the ECB printing a few hundred billion euros.  The ECB will then have joined the other major central banks in the Race to the Bottom and, as usual, the ECB will once again have proved itself to be the slowest to act.

So two central banks have led the way and raised interest rates (Australia and Norway), starting their journey on the long way back to interest-rate normality.  But it does not necessarily follow that just because two commodity-linked countries have started to hike rates, the Fed, BoE and the ECB are about to follow suit anytime soon. Speculation that the Fed and BoE are contemplating rate hikes is way too premature – the order of events will surely be for Quantitative Easing spending to be halted first and only then will the central bankers turn to taking back some of the rate cuts they have implemented since the summer of 2007.

The US has recently reported GDP turning positive in the third quarter of this year but the US economy is still far too weak for the Fed to risk halting QE anytime soon, let alone even think about raising interest rates from their current floor of 0.25%. One positive quarter of GDP is just the start of a potential recovery  (which could easily fizzle out again next year) and the Fed made it clear in their Fomc statement earlier this week that rates are staying put “for an extended period” and the Fed won’t even finish spending its current $1.75 trillion QE money until the end of March 2010. As was announced today, US unemployment is still rising and has now reached 10.2%.

Similarly the Bank of England this week increased by £25 bln its QE target to £200 bln, to be fully spent by the end of January 2010.  The BoE will most likely decide to print even more money if GDP does not return to growth in Q4 (after the surprise of the UK posting another quarter of recession in Q3).  As the BoE will not raise rates ahead of next year’s General Election, theoretically the ECB is in line to be the first of the major Western central banks to implement a rate hike as they never embarked upon QE in the first place.  However the jury is out on whether the ECB will raise rates with Spanish unemployment of almost 20% and with Ireland looking set to go to the IMF to seek a loan.

Inflationary pressures will not be seen in the UK until a lot more of the £200 bln QE money finds its way off deposit at the BoE (where £151 bln currently sits) and out into the wider economy where it can begin to chase the price of goods & services higher.  Therefore the BoE will only come under pressure to raise rates in the near term if the Pound Sterling collapses.

So the sight of central banks raising rates looks to be spotted for the time being only in the economies of the world which export commodities.  China will probably be the first Asian central bank to increase rates because the Yuan is closely tied to the US Dollar and other Asian countries do not want to raise rates and cause their currencies to appreciate against the Dollar or the Yuan.

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.

The head of the ECB Jean-Claude Trichet was most insistent during his press conference after the latest ECB meeting that their proposed purchases of €60 bln of “covered bonds” (mostly mortgage-backed securities issued mainly by German banks) did not mean that the ECB was commencing quantitative easing.  His exact words during the Q&A session of the press conference were “we are not at all embarking on Quantitative Easing”. 

Instead the €60 bln covered bond purchase plan was presented as providing “enhanced credit support” to the covered bond market which will help to improve the spreads, depth & liquidity of this particular market, seen by the ECB to be in particular trouble at the moment.

The Bundesbank has clearly dug its heels in over the ECB going down the road of QE and has compromised by agreeing to throw €60 bln instead at the covered bond market.  Good to see the old City adage “If there is a problem then throw money at it until it goes away” has been taken on board by the burghers of Frankfurt.

Meanwhile the Bank of England has taken that particular City adage to heart by expanding its QE program from £75 bln to £125 bln.  And if that does not do the trick then expect the BoE to throw even more money at the problem…there is no shortage of money to spend when the BoE can just print it (even if they describe this printing as “electronically crediting the accounts of those instituitions” which sell securities to the Asset Purchase Facility).  The BoE is aiming to ease the flow of credit throughout the economy by purchasing gilts (mostly).  It hopes the selling institutions will re-invest the proceeds elsewhere, thereby boosting asset prices & tightening credit spreads.  It also hopes that some of this money will leak out into the wider economy and end up as spending on goods & services.  By restricting their buying to gilts, the BoE will be unlikely to lose money as they are financing their purchases at near-zero rates of interest and will likely hold the gilts to maturity.  By spending a big percentage of the Government’s borrowing requirement, the BoE is also hoping its purchases will help to avoid private borrowers being “crowded out” by the deluge of gilts being issued.  Expect the BoE to spend much, much more than £125 bln before its Quantitative Easing program comes to an end.  They truly are going to throw a great deal of money at this problem until it goes away.