Posted on 2020-03-18 20:11:00
[ Show older headlines ]
A dusty concept called the regression theorem suggests the most fragile of the major currencies is the euro. This states that in the users’ collective mind its validity as money is derived through experience. The fact it was money yesterday, and in the days, weeks, months and years in the past confirms its status: the longer the better. For the fiat currencies with the longest history, their status as money was derived from their role as a gold substitute, linking their credibility to sound money in the distant past.
In the euro’s case, it derived its original status from the fiat currencies it replaced and is only twenty-one years old. In a generally stable economic and monetary situation the lack of a longer history of regression may not matter, but it could be more easily destabilised than a more established currency at a time of crisis. Despite the Lehman catastrophe, the subsequent banking crisis in Europe and negative interest rates, the euro has so far survived intact.
The fact it has done so is in large measure due to the lack of any alternative for the 340 million eurozone residents. Perhaps its survivability has been enhanced by the convenience of non-cash transactions. In any event, a population mandated to use a state issued currency finds it is in its interests to accept its validity as a circulating medium and only abandons it as a last resort. It is when approaching that point that the regression theorem will matter.
That is a consideration for domestic users of the euro. Meanwhile, foreigners have voted with their feet, driving the rate down in recent years from $1.60 in 2008 to $1.05 in 2016, and from $1.24 in 2018 to $108 recently. It has been the principal counterpart to a rising dollar expressed in the latter’s trade weighted index. Behind these moves there is the net effect of trade balances and speculative flows.
In 2019 the Eurozone’s balance of trade was a positive $175bn, while the US trade deficit was $667bn. The sharp difference between the two economies represented a strong headwind in favour of the euro and against the dollar, but since 2018 it was more than overcome by the pull of interest rate differences. While the ECB maintained a negative deposit rate, US-based hedge funds through the fx swap market shorted the euro and bought dollars to benefit from interest rate differentials.
Since April 2018, when it became clear that President Trump’s tax policies would stimulate the US economy the fx swap trade was on. There can be no knowing the true size of it, but it was significant enough to force the Fed to intervene in the repo market to provide extra liquidity from last September to this day.
The Fed has now reduced its funds rate by fifty basis points to 1.0-1.5% and the 13-week T-bill is leading the way to yet lower yields by yielding only 0.675%. Given that prime brokers fund their inventory at the fed funds rate, they are still losing money, so the Fed will be forced to lower the FFR again to 0.5%-0.75% to avoid disrupting the T-bill market. Even that assumes no further fall in T-bill discounts, but it does mean that interest differentials between dollars and euros will fall again, with consequences.
The declining profitability of fx swaps out of both euros and Japanese yen and into dollars plus increasing liquidity and counterparty risks means hedge funds should be aggressively unwinding their positions. Already, in recent days we have seen the yen rise from 112 to the dollar to 106.9 (note that a decline in the rate signals a stronger yen). And the euro against the dollar has gone from under 1.08 to 1.1175. The effect on the dollar’s trade weighted index has been dramatic, as shown in Figure 1 below.
The start of the fx swap trade for hedge funds is highlighted by the solid arrow, when in April 2018 it became clear that President Trump’s fiscal policies would lead to higher dollar rates and bond yields relative to both those of the euro and the yen, but particularly against the euro due to the index’s weighting in favour of it. While the bull market persisted, for most of the time it has been in the form of a weak broadening top delineated by the pecked lines. It is in this context we can see the impact of the coronavirus on dollar exchange rates, with the TWI suddenly falling by about 2½%. If it breaches 96.5, we will have technical confirmation the dollar is due to fall significantly, possibly quickly, against the euro.
In the short term, the unwinding of fx swaps combined with the relative trade imbalances with the dollar are the reason their closure could drive the exchange rate for the euro higher, likely to provoke the ECB into attempts to offset it. Policymakers enamoured of the Taylor rule will argue for deeper negative rates, a move that favours spendthrift governments but does nothing for the real economies in the EU. Worse, it comes at a time when overleveraged eurozone banks will be reducing outstanding bank credit, as loans reflecting dollar swaps positions taken out by both hedge funds and commercial entities are being wound down. And they will also be trying to reduce their loan exposure to businesses whose cashflows are being undermined by the coronavirus. In short, bank credit faces an imploding pull.