EURUSD Down, Equity Down On ECB Delivering Deeply Negative Interest Rates by Fasanara Capital
ECB likely to act forcefully on March 10th
European inflation forwards (see chart below) are today well below the levels at which the ECB felt compelled to launch QE1 on 22nd January 2015. EUR trade-weighted index is also stronger today than it was back then. Moreover, economic activity indicators are softening, credit formation remains weak, the global outlook for international trade and geopolitical risks deteriorates. We believe the ECB may deliver as follows:
- Depo rate cut to -0.5% from -0.30% (two-tiered system to avoid hitting on banks too visibly, similarly to what Japan did last month). The ground prepared for further cuts to -1%/-1.5%.
- QE monthly purchases increased by Eur 15bn to approx. Eur 75bn
- Possibly, hints to the fact that the ECB may consider buying corporate bonds / bank bonds directly (NPLs unlikely, would be a game changer)
Market Reaction medium-term: EURUSD down, Equity down
After an initial Pavlonian reflexive reaction, we think that the typical correlation between EURUSD and European equities is to break down in the weeks after the ECB meeting of the 10th March. EURUSD likely to move lower, while Equities may stay weak/volatile, and at risk of further sizeable downside, over the medium term.
The ECB cutting rates further into negative territory weakens the EUR against the USD but also hits hard the profitability of the banking sector, a key driver of overall equity markets
- EURUSD likely to descend to parity over the medium term, on implosion of European rates below zero. As we speak, already all 2year European government bonds yield negatively, except Portugal & Greece. Soon, it might be all 5yr European government bonds, further shrinking the amount of available government collateral in Europe to well below 50%. Reserve managers may find it hard, let alone inefficient, to park cash in EUR even if they wish to.
- Typically, over the past years, Equity markets have rallied on increased QE or more expansionary policies. This time around, however, we believe that any equity market rally may be short-lived and represent a good entry point for building short positions. No bank is ever designed to function in durable negative rates environment: its business model is impaired, needs a rethink/restructuring. It is a profitability issue, not a balance sheet problem. Banks’ capitalisation then, however healthy it may seem today, perhaps will have to be looked at as no more but the number of years of negative profitability it can withstand before a recap is needed, eventually. A fragile banking sector is the Achilles heel of the equity market overall, paving the way for gap risks to the downside.
Chart: Eur 5y5y Inflation Forwards
Chart: EUR Trade Weighted Index
The Real New News: Deeply Negative Interest Rates
To us, the real new news of the past few weeks is not China (well known risk), is not Oil (well known risk), is not FED hiking rates (hardly new) is not European banking sector (old news, if not for the impact of durable negative rates, see below). We believe the new news is the Bank of Japan cutting rates into negative territory, unexpectedly so.
It seems that, given deflationary pressures (Structural Deflation) and lack of policy space (QE is an advanced stage, with decreasing marginal effectiveness), deeply negative interest rates are the way to go for end-of-cycle Central Banks’ policymaking.
Perhaps by now, negative rates are viewed as the preferred policy reaction to the growing risk of deflation. Deflation is fought by lowering real rates below nominal GDP growth rates, so as to tackle excessive real debt ratios (‘financial repression’ similar to what was resorted to after WWII to reduce the debt burden in real terms).
No safe haven left in government bonds. Negative rates are all around us, globally:
- On a 2yr horizon, all European government bonds yield negatively, except Portugal & Greece.
- 5 Central Banks in the world have now adopted negative rates (SNB at -0.75%, Sweden RiksBank at -1.10%, Denmark at -0.65%, ECB at -0.30% and BoJ at -0.10%). This is equal to 20% of the world’s GDP (WSJ Article)
- 10 countries have 5yr govt bonds with negative yields (ZeroHedge Article)
- As of yesterday, $7 trillion worth of govies (~30% of global sovereign bonds) offer negative rates (BBG Article)
Definition of Safe Haven needs a rethink, or is simply no longer amongst us. If the definition of safe haven is the inability to experience a loss, such definition is negated by such government bonds now offering the certainty of a capital loss at maturity, and the possibility of a larger paper loss (mark-to-market volatility) before then. In between, they can now even experience 5-sigma volatility events, like it happened last April/May on 10yr Bunds moving from 5bips yields to 105bips yields violently, in short order.
Secular Stagnation & Structural Deflation
To us, the most fundamental forces visible in the economic landscape are Structural Deflation and Secular Stagnation. Such conceptual framework entails an economy characterized as ‘depressed’, weak global aggregate demand, less industry, durable goods and manufacturing vis-a-vis services and digital goods, and therefore lower need for functional commodities for all intents and purposes.
The basic point of our take on the subject is that the current depressed economy, with its low inflation, low GDP growth rates, low potential GDP growth, decelerating working population growth rates, low interest rates, low productivity, is not a consequence of the Global Financial Crisis (‘GFC’) and the Lehman moment, but rather the result of more structural forces who have been at play for decades. The GFC has at best been an accelerator, weighting on a more chronic long-running pandemic. In a nutshell, the few drivers of Structural Stagnation can be isolated as follows:
- Falling working population. Not only visible in Japan, Europe ..but also and also in the USA, China.
- Over-indebtedness. Negative inflation rates increase the real value of liabilities and their drag on growth.
- Falling productivity of Credit. Diminishing effects of monetary printing and the credit cycle.
- Technological advances. ‘Amazon effect’, fourth industrial revolution, Video.
- Falling Productivity rates. At 0% for 4 years now, from historical 1.5% annual.
We characterize our conceptual framework on Secular Stagnation and Structural Deflation in our January 2016 Investment Outlook (pages 13-14) as well as in the attached PRESENTATION (pages 54-75).
Fasanara Capital January 2016 Investment Outlook
Fasanara Capital Presentation