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Friday, January 20, 2012

Citi's Contrary FX View: ECB Easing Would Be EUR Positive

Tyler Durden's picture

One won't find many orthodox strategists who believe that currency printing, and thus dilution, is favorable for said currency. Yet they do exist (as a reminder, this is precisely what saved the REITs back in early 2009, who came to market with massively dilutive follow on offerings, but the fact that they had market access was enough for investors to buy the stock despite the dilution). One among them is Citi's Steven Englander who has released a rather provocative piece in which he claims that as a result of reduction in tail risk, or the possibility of aggressive ECB bond buying (and implicitly, Englander suggests that what we believe is a core correlation: between the sizes of the Fed/ECB balance sheets and the relative value of the respective currencies, is not as important as we suggest), the "EUR will be stronger if the ECB compromises its ‘principles’, but succeeds in convincing investors that the sovereign risk is limited to the smaller peripherals, rather than the core." Currency stronger on central bank printing? And by implication, an x-trillion LTRO being FX positive (and thus risk-FX recoupling)? We have heard stranger things. And remember it is the bizarro market. And finally, Morgan Stanley, which won that shootout with Goldman's Stolper two months ago on the EURUSD, has just turned tactically bullish on the currency (more shortly). For now, here is how Steven Englander explains his contrarian view.
From Citi
EUR tail risk matters more than liquidity
  • Empirical evidence points to tail risk, rather than liquidity or balance sheet expansion as the key driver of the euro
  • The liquidity explanation has a hard time explaining EUR moves before H2 2011 or the mini cycles within H2 2011
  • The consensus short EUR trade is based on the view that the EUR will fall if tail risk continues to rise and will also fall if the ECB acts aggressively to eliminate tail risk.
  • There is much more two-way EUR risk than the market thinks
When I meet with clients the most heated discussion often focuses on what is driving the EUR. This doesn’t have much impact on the short term EUR view – we are with the majority in expecting the EUR to fall below 1.25 in coming months. But there are clear differences on the longer term front. When I make the case that a reduction in tail risk will lead to a stronger euro, I find significant pushback. The analytical issue is whether a reduction in tail risk caused by aggressive ECB bond buying would be EUR-positive because investors would find euro zone assets to be attractive, or whether it would be EUR-negative because investors would recoil at seeing such a large liquidity intervention.
My main conclusion is that the evidence favors the tail risk view – the EUR will be stronger if the ECB compromises its ‘principles’, but succeeds in convincing investors that the sovereign risk is limited to the smaller peripherals, rather than the core. My secondary conclusion is that the evidence is not completely one sided, so it is worth thinking about how the argument could be settled.
The liquidity view
There is a visible correlation of relative balance sheet size and EURUSD in recent months. However, the correlation was less compelling in 2008/2009 and even during H1 2010. There is a broad correlation since mid-2010 which roughly corresponds to the initiation and unwinding of QE2 and the ECB’s recent balance sheet expansion (which began mid-2010 and thus predates the recent LTRO).

In fact USD strength was accompanied by sharp Fed balance sheet expansion at the end of 2008. The bigger driver of USD strength appears to have been position cutting and risk aversion in the aftermath of the Lehman bankruptcy. One could make the case that right until the end of 2011, the peaks and troughs of the EUR better matched the ebbs and flows of risk appetite (proxied by the S&P in Figure 2) rather than the relative balance sheet size. The balance sheet expansion explanation at best is situational, rather than structural.
The second issue is statistical in nature but more subtle. If you look closely at Figure 1, the correlation between EUR moves and relative balance sheet size is visible in a trend sense but mini peaks and troughs do not match up well over the last six months. That can be a statistical warning that the relationship is not robust.
EUR rebound if sovereign risks abate
If we take a shorter term view we find a much greater correspondence between the EUR and moves in euro zone risk measures even in H2 2011. In fact we find that the peak and trough correspondence between the EUR and the euro zone banks index (Figure 3) and the Italy-Germany 10year yield spread (Figure 4) and the EUR is tighter than the correspondence with liquidity or central bank balance sheets.

While these correlations are far from perfect, one sees more of a reflection of recent moves in the EUR in the evolution of these factors than in the very smooth evolution of the relative monetary base. More formal analysis of what factors are correlated with changes in the EUR also points to these risk factors.
Such analysis does not close the door on the central bank asset side but does provide an alternative explanation of the EUR’s move that is difficult to dismiss.
One development that would put the balance sheet explanation under stress would be if the EUR managed a significant rally that was correlated with improvement in risk indicators. Keep in mind that central bank balance sheets tend to be grow with a high degree of inertia. So the balance sheet explanation is unlikely to work if relative balance sheets evolve smoothly and currencies with a high degree of volatility.
Conversely, if euro zone measure of risk conditions improve and the euro keeps falling that would be an indication that investor concerns went beyond the tail risk that I have been emphasizing here.
An obvious question is why we don’t use interest rate differentials between Germany and the US as a candidate driver of the EUR. Most of the time such spreads are a good proxy for the relative policy stance of central banks and that relative policy stance is the key driver of currencies. However, we would argue in the most recent period that the rate spreads themselves are largely driven by sovereign risk. German yields have gone down as peripheral yields have gone up, so the yield spreads themselves are largely driven by tail risk. At best their interpretation is ambiguous, at worst we may be drawing the exact wrong conclusion if we view lower German yields as an indicator of policy ease rather than peripheral stress.
Why does it matter?
Many (and possibly most) clients and colleagues hold the view that the euro is in for a pronounced decline over the last year. Either euro zone officials will fail to convince investors that there will be no core defaults in the euro zone or they will convince investors that there will be no default by pumping up liquidity and ECB balance sheets. This view leads to unambiguous pessimism on the EUR because both the problem and the solution lead to a weaker euro. This is perhaps why EUR negative positioning has become so pronounced in recent weeks.
By contrast, the view advocated here offers two-sided risk. If what investors want is comfort that there will be no core default or euro zone dropouts, even measures that come out of a non-orthodox central bank playbook will strengthen the euro. So far the evidence is more supportive of the EUR recovery on tail risk reduction view. But we admit that it is not yet conclusive.
In our view the real determinant of EUR strength or weakness will be whether euro zone assets are attractive enough for foreign investors to want to buy them in preference to USD. Reducing tail risk, rather than central banking orthodoxy, looks like the more likely path to EUR strength.

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