What the G8 communiqué didn’t say

June 15, 2009 — Mitul Kotecha

There was a stark contrast between the outcome of the weekend’s G8 meeting in Lecce, Italy, and April’s G20 summit in London.  For a start, the tone was far more positive than in London, with Finance Minsters attending the meeting indicating that economic forecasts may need to be revised upwards rather than the steady stream of downward revisions seen over recent months.

The overall tone was one of cautious optimism.  The communiqué noted “there are signs of stabilization in our economies, including a recovery of stock markets, a decline in interest rate spreads, improved business and consumer confidence”.  However, at the behest of the UK the comments “but the situation remains uncertain and significant risks remain to economic and financial stability” was inserted into the final communiqué.   Such an inclusion is logical and at least suggests that officials are not getting to carried away with the improvement in recent data. 

Officials also began discussing “exit strategies” in terms of withdrawing massive global monetary and fiscal stimulus and even requested the IMF look at the issue in more detail.  Whilst it is premature to even discuss exit strategies the comments were clearly aimed at easing bond market concerns about widening fiscal deficits and inflation risks.  As Tim Geithner highlighted, recovery would be stronger if “if we make clear today how we get back to fiscal sustainability when the storm has fully passed”.   Nonetheless, a mere discussion about exit strategy is highly unlikely to remove the current angst that has built up in bond markets globally. 

Additionally, the communiqué included a commitment to develop standards governing the conduct of international business and finance, international regulatory reform, exchange of information for tax purposes and a commitment to refrain from protectionism.   None of these points will move markets this week and all were unsurprising discussion points. 

So what was missing?  The issue of stress tests on European banks was left out of the final communiqué even though it was discussed at the meeting. Reported disagreements with Germany and France over transparency over the publication of stress test results meant that an agreement could not be reached.  This is a big disappointment.  I have written about the issue in two previous posts “European economy in a whole lot of trouble” and “Stress testing European and UK banks” on my blog Econometer.   The fact that more wasn’t done will mean that uncertainty about the health of balance sheets in particular of banks in Germany will remain a constraint to European recovery.  At the least it will make it increasingly likely that in addition to a sharp decline in European growth this year GDP could also drop in 2010.

In addition, economic data continues to lag in the Eurozone compared to the improving signs in the US and elsewhere as highlighted by the huge 21% annual drop in April Eurozone industrial production at the end of last week.  This data even led to another omission with reference to “encouraging figures in the manufacturing sector” previously included in the draft dropped in the final communiqué.   It is clearly too early to talk about manufacturing recovery.

Also missing in the final communiqué was any reference to currencies. Although it was always unlikely that FX would be a major topic at the meeting due to the absence of central bankers attending, the drop in the dollar and concerns from foreign official investors (see a recent post on my blog “Are foreign investors really turning away from US debt”) raised the prospect that there would be some international backing of the US “strong dollar” policy led by the US. 

In the event there wasn’t any comment, but dollar positive comments on the sidelines of the meeting will likely limit any pressure on the dollar this week.  The dollar will be helped by comments on the sidelines of the G8 meeting as well as important comments from Russian Finance Minister Kudrin who stated that he has full confidence in the dollar with no immediate plans to move to a new reserve currency. Ahead of the meeting of BRIC countries this week the comments from Russia add further evidence that there will be no plan to move away from the dollar. Moreover, geopolitical tensions including the protests over the results of Iran’s elections as well as more jawboning from North Korea will work in favour of the dollar this week. 

The euro could look especially vulnerable this week. The lack of attention on European banks stress tests will be a disappointment for those hoping for more transparency and will act as a further drag on the euro.  This is likely to see the euro struggle to make much headway this week, with the recent high above 1.43 likely to provide tough resistance to any move higher in EUR/USD, with a bigger risk of a pull back towards the 1.37-1.38 levels.

Posted in bank rescue, Bond markets, central banks, Currencies, Economics, Economy, Europe, Financial crisis, Germany, Monetary Policy, US. Tags: , , , , , , , , , , , , , , , , , , , , , , , . 2 Comments »

European economy in a whole lot of trouble

June 11, 2009 — Mitul Kotecha

Concerns about the health of European banks, particularly German banks, and the pace of Eurozone economic recovery have intensified.  Warnings by the European Central Bank’s (ECB) about further financial sector weakness if there is not a “V” shaped recovery reveal the extent of such concerns.  Attention is increasingly focusing on a lack of transparency and the fact that European regulators are not releasing the results of industry wide stress tests in contrast to the recently released results of US bank stress tests.  Such problems have not gone unnoticed in Germany and even the bank regulator in the country said recently that toxic assets at German bank could blow up “like a grenade”. 

It’s worth noting that the IMF’s estimates for future writedowns and capital requirements in its financial stability report suggest that European banks have much more to do than their US counterparts. See an earlier post titled “Stress testing European and UK banks”.   The IMF repeated its warnings this week as it wrapped up its consultations with European officials, whilst US Treasury Secretary Geithner is set to pressure European authorities to carry out tougher stress tests at this week’s G8 meeting.   Germany has taken some steps towards resolving its banking sector problems and this week the German cabinet agreed to support a “bad bank” plan.  Nonetheless, the task will not be easy as Germany is estimated to have over $1 billion in toxic assets, with consolidation of the regionally owned Landesbanken a major concern. 

The prospect of a “V” shaped recovery in Europe is extremely limited.  Warnings about the pace of eurozone economic recovery should be taken seriously.  However, some officials such as the ECB’s Quaden are already talking about an exit strategy, which looks very premature given the likely slower recovery in the eurozone compared to the US over the coming months.  Whilst the US economy is set to see positive growth next year, albeit below trend, Europe is facing a second year of economic contraction.   Moreover, the drop in Eurozone growth in 2009 is likely to be far steeper than the US, with the economy set to decline by close to 5%.  The bigger than forecast 21.6% annual drop in German industrial production in April and the 29% annual drop in April exports released this week provided a timely reminder of the pressure on Eurozone’s biggest economy.  Given the fact that the German economy is still highly reliant on export growth the data were particularly worrying. 

Against this background and with inflation continuing to drop, the ECB is highly unlikely to raise interest rates until the beginning of 2011 at the earliest.  The fact that ECB officials are even talking about an exit strategy seems completely at odds with the reality of the situation.  As it is the ECB’s EUR 60 billion covered bond purchase plan will have a limited impact, and the policy can hardly be labeled as aggressive.  

Even so, there is no indication that the ECB is about to embark on more aggressive credit or quantitative easing.   The latest ECB monthly report predicts that growth in the eurozone will begin to pick up by the middle of next year but admits that inflation could turn negative over coming months.   Surely this will give the ECB further room to maintain easy monetary policy.   Once again disagreements within a 16 nation ECB council will result in compromise at a time when the eurozone economy is crying out for decisive policy actions.   Growth and banking sector concerns will also be a factor that helps to prevent the euro from fully capitalising on any weakness in the dollar.

Posted in central banks, Economics, Economy, Europe, Financial crisis, Germany, Interest rates, Monetary Policy. Tags: , , , , , , , , , , , , , , , , , , . 4 Comments »

Are currency market dynamics shifting?

June 8, 2009 — Mitul Kotecha

There has been a major shift in market pricing for US interest rates following the US jobs report and comments from Fed officials including Atlanta Fed president Lockhart, suggesting that the Fed should not wait too long before tightening monetary policy.  As a result the implied yield on the December 09 3-month eurodollar futures contract has spiked by around 50bps since the middle of last week and markets have now moved to pricing in a US rate hike by year.  This looks wildly premature given the likely absence of inflation pressures for many months to come. 

The most interesting reaction to the shift in interest rate expectations was exhibited by the dollar which has managed to register solid gains over the last couple of days indicative of the past relationship between the dollar and interest rate expectations.  The odd thing about the strengthening in the dollar is that it has come at a time when risk appetite has continued to improve, suggesting that the strong risk appetite/dollar relationship that has been in place for much of the past year could be diminishing in strength.  For instance, the correlation between various dollar crosses and the VIX volatility index has been higher over the last few months than it has been in previous years.   

Admittedly its early days and the bounce in the dollar may just have reflected a market that was positioned very short dollars.  There was already signs of some short covering prior to the release of the US May jobs report as reflected in the CFTC IMM commitment of traders’ report which showed that net aggregate dollar speculative positioning (vs. EUR, JPY, GBP, AUD, NZD, CAD and CHF) improved for the first time in five weeks.  It is not inconceivable that investors have continued to cover short positions over the last few days.  

Nonetheless, it is difficult to ignore the possibility that currency market dynamics may be shifting back towards interest rate differentials as a key FX driver.  Over recent months the interest rate / FX relationship had all but broken down as reflected in very low and insignificant correlations between interest rate differentials and various currency pairs.  This could be changing and as interest rate markets begin to price in higher rates the relationship with currency markets may once again be strengthening.  

The risk for the dollar is that this tightening in US interest rate expectations looks premature.   It seems highly unlikely that the Fed will raise rates this year which points to the risk of a turnaround in rate expectations at some point over coming weeks and months.  In turn this suggests that the dollar could come under renewed pressure in the event of a dovish shift in US interest rate markets.  Even so, this is a factor to consider further out.  Over the next few days such a shift is unlikely and the dollar is likely to hold onto and even extend its gains as markets continue to ponder the probability that the Fed tightens policy sooner rather than later.

Posted in central banks, Currencies, Economics, Economy, Financial crisis, Interest rates, US. Tags: , , , , , , , , , , , , , , , . Leave a Comment »

Backing the dollar

June 3, 2009 — Mitul Kotecha

There has been no let up in the bullish tone to markets over recent weeks. Optimism is dominating. Meanwhile, commodity prices continue to remain firmly supported, with the CRB commodities index up around 30% from its early March low. Bank funding has improved sharply, with indicators such as the Libor-OIS spread moving to its lowest spread since the beginning of February 2008 whilst the Ted spread is now close to where it was all the way back in August 2007.

Conversely, there is not much sign of a let up in pressure on the dollar despite assurances from US Treasury Secretary Geithner during his visit to China. Much of the move in the dollar continues to be driven by improvements in risk appetite but worries about the sustainability of foreign buying of US assets have increased too.

Russia’s proposal to create a new supranational currency has dealt the dollar another blow but it was notable that India, China and South Korea were reported to express confidence in the dollar, stating that there is no alternative to the dollar as a reserve currency. Such comments highlight that despite political motivation to move away from the dollar it is no easy process.

The comments from India, China and South Korea, three of the world’s biggest reserve holders reflect the growing concerns from official accounts about 1) dollar weakness getting out of control and 2) US bond yields pushing higher. Even though foreign central banks will continue to diversify the last thing they want to do is to destroy the value of their massive amounts of US asset holdings so don’t expect a quick move out of dollars from central banks despite the rhetoric from Russia and others.

Russia has said that a debate about the dominance of the USD will take place when BRIC (Brazil, Russia, India and China) countries meet on June 16. Although the rhetoric from Russia may add to dollar worries the reality is that it is highly unlikely that any form of concrete plan will be easily developed to shift away from the dollar. Political motivations aside, even Russian President Medvedev admits it’s an “idea for the future”.

Posted in Bond markets, central banks, China, Commodities, Currencies, Financial crisis, India, US. Tags: , , , , , , , , , , , , , , , . 1 Comment »

Are foreign investors really turning away from US debt?

May 29, 2009 — Mitul Kotecha

The press has been full of stories about the dangers to US credit ratings and growing concerns by foreign official investors about the value of their holdings of US Treasury bonds.   A combination of concerns about the rising US fiscal deficit, Fed quantitative easing and potential monetization of US debt, have accumulated to fuel such fears. Given the symbiotic relationship between China and the US it is perhaps unsurprising that China has been one of the most vocal critics. I have highlighted this in past posts, especially related to the risks to the US dollar. Please refer to US dolllar beaten by the bears and US dolllar under pressure. However, my concerns that foreign investors have been shunning US Treasuries recently may have proved somewhat premature.

Should China or other large reserves holders pull out of US asset markets, it would imply a sharp rise in US bond yields and a much weaker dollar.  However, it is not easy for China or any other central bank to act on such concerns.  China is faced with a “dollar trap” in that any decline in their buying of US Treasuries would undoubtedly reduce the value of their existing Treasury holdings as well as drive up the value of the Chinese yuan as the dollar weakens.  Such a self defeating policy would clearly be unwelcome. 

One solution that China has proposed to reduce the global reliance on the dollar and in turn US assets was to make greater use of Special Drawing Rights (SDRs) which I discussed in a previous post, but in reality this would be fraught with technical difficulties and would in any case take years to achieve.  Nor will it be quick or easy for China to persuade other countries to make more use of the yuan in the place of the dollar.  The first problem in doing so is that fact that the yuan is not a convertible currency and therefore foreign holders would have difficulties in doing much with the currency.  

Foreign official concerns are understandable but whether this translates into a major drop in buying of US Treasuries is another issue all together.  Foreign countries have been gradually reducing their share of dollars in foreign exchange reserves over a period of years.  This is supported by IMF data which shows that dollar holdings in the composition of foreign exchange reserves have fallen from over 70% in 1999 to around 64% at the end of last year.

In contrast the share of euro in global foreign exchange reserves has increased to 27% from 18% over the same period.  This process of diversification likely reflects the growing importance of other major currencies in terms of trade and capital flows, especially the euro, but the pace of diversification can hardly be labeled as rapid. 

Importantly, there is no sign that there has been an acceleration of diversification over recent weeks or months.  Fed custody holdings for foreign official investors have held up well.  In fact, these holdings have actually increased over recent weeks.  Moreover, the share of indirect bids (foreign official participation) in US Treasury auctions have been strong over recent weeks.  Taken together it provides yet more evidence that foreign official investors haven’t shifted away from US bonds despite all the rhetoric. 

Posted in Asia, Bond markets, central banks, China, Currencies, Economics, Economy, Europe, US, US administration. Tags: , , , , , , , , , , , , , , , , , , , , . 5 Comments »
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