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Forex Analysis

A Possible ECB Intervention In The Corporate Debt Market

Written by A Forex View From Afar on Monday, March 30, 2009

Following the European Central Bank’s tradition to pre-announce its important decisions, the Vice President, Lucas Papademos, said last week that the central bank could start buying corporate bonds. This comes after Mr. Trichet announced, at the last interest rate meeting, that the bank is preparing to adopt a new set of “unconventional” policies.

According to Mr. Papademos, the ECB could intervene in the secondary corporate debt market to bring yields down. A similar decision was taken by the Bank of England, which decided to use up to 75 billion pounds to buy corporate debt, and more recently, by the Bank of Japan. At the same time, the Fed decided a slightly different approach, to buy government debt and mortgages.

Most likely, the ECB are preparing to take this stance because they cannot intervene in the government debt market, unlike the other central banks. This happens because the ECB is formed by 16 countries, and such a move would raise many technical and fundamental problems regarding what country’s debt to buy, and in what quantity.

In Europe, a staggering majority of private loans are issued by commercial banks. As the credit crisis struck the financial world, banks began de-leveraging their balance sheets and cutting back on new lending programs. A possible ECB intervention would loosen the tight credit conditions, to some extent.

Market participants expect this measure to be announced this week, at the ECB press conference. However, its effect in the currency market is still unknown because of the lack of any further details about the plan itself. However, if the ECB disappoints, the euro will probably see strong selling pressure.

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The U.K. Dilemma

Written by A Forex View From Afar on Thursday, March 26, 2009

Even though the U.K. economy is shrinking at a very fast pace, around 1.5% in Q4, the U.K. Prime Minister gave in to the idea of a new stimulus package.

Currently, the country’s outlook is rather gloomy, having the most important economic indicators near record lows. Retails sales continued to decline in February, while sales of small stores dropped the most since 1986, when records first began. Mortgage approvals are holding barely above record low levels, while unemployment claims jumped in February the most on record sending the jobless rate to a decade high. Private forecasters have said that the U.K. economy will shrink between -3% and -4% this year.

Despite the very poor outlook surrounding the economy, the governments’ hands appear to be tied. Both the Chairman of the Bank of England (BoE), Mervyn King, and the Chancellor of the Exchequer, Alistair Darling, have expressed their concerns about the deterioration of the public finances.

On top of this, yesterday, the U.K. Treasury failed to sell all the intended gilts at auction for the first time in seven years. This shows that investors are finding the debt issued by the U.K. government overvalued.

Every time the Treasury fails so sell its debt, it adds an additional burden on the taxpayers’ shoulders as investors request higher yields to be paid. A new stimulus package would imply that the Treasury has to sell even more debt, something that would have a substantial effect on the gilt’s value.

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German Economy Set To Contract?

Written by A Forex View From Afar on Tuesday, March 24, 2009

The latest forecast for Germany points out that the economy might contract a whopping 6% this year, as the credit crisis reduces foreign demand for German made goods.

Commerzbank, one of the leading German banks, said that the German economy might contract 6% to 7% in 2009. At the same time, Deutsche Bank and BNP Paribas project a 5% contraction in 2009 for the German economy. The German Institute for Economic Research estimates that the economy will contract between 4% and 5% this year.

By far, these estimates are the worst for any European economy, including the much-spoken-about Eastern Europe. Among the developed countries, only Germany and Japan share such an downbeat forecast.

As was said before, the export component is the biggest drag on the German GDP. Until now, exports have dropped by 20%, while the outlook clearly lies to the downside. Even if the global economy would miraculously bottom, demand and thus exports would still need some time before picking up again. Exports account for almost 40% of the German GDP.

Obviously, Germany is not the only victim of the credit crisis in Europe. Today, the Czech government collapsed, by gaining a no-confidence vote from the parliament, while just yesterday, the Hungarian government resigned. Wonder who will follow next?

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The Toxic Asset Plan

Written by A Forex View From Afar on Tuesday, March 24, 2009

Today, the equity markets around the globe rallied as the Treasury was unveiling its plan, meant to save the financial system.

Overall, the plan looks simple, since its only scope is to provide liquidity in the secondary market. This is because the Treasury treats the current credit crunch as a liquidity problem, and (still) considers the banks’ assets fundamentally sound.

The newly announced plan proposes to use the taxpayer’s money to leverage the investors’ funds, up to 6:1 for a loan, and 1:2 in order to buy the assets. In addition, these loans will be insured by the FDIC, so in essence, investors would support only a very small fraction of the actual cost of the distressed asset.

However, this still does not guarantee that investors will overpay for these assets, because the private investors will be the ones to suffer the first losses. Therefore, it will be in the investors’ best interest to come up with a low bid for the toxic assets, reducing their risk exposure.

In this case, banks will not be tempted to sell their assets. It would seem that, if these assets are really worth something (the Treasury treats them as fundamentally undervalued), why would banks want sell them at huge discounts. Secondly, many of these assets are still overvalued on the bank’s balance sheets. Even if the bank would want to sell them, they would have to write-down their value first, something that might not be too good either for the bank or for the overall system because it will trigger systematic write-downs.

With a bit of luck, maybe the new asset plan will get some traction in the financial markets otherwise today’s rally might turn around very quick. Additionally, as some market commentators have pointed out, it might be among the administration’s last shots at saving the financial markets.

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One-step forward or one-step back?

Written by A Forex View From Afar on Friday, March 20, 2009

The Fed’s decision to buy up to $300 billion of long-term Treasuries and double the purchases of mortgages to $1.45 billion was a surprise to most market participants.

The surprise is even bigger, if we add that just two weeks ago the Chairman of the New York Fed, seen as the second man in Federal Reserve, said “at this point in time the Fed has judged buying long-term Treasuries is not the most efficient means of easing financial market conditions”. This is a huge change in just two weeks, and it certainly raises some questions as to why the Fed made this decision, if it is not efficient.

Moreover, Mr. Bernanke has build an academic reputation as a supporter of the inflation targeting regime, which implies that the central bank must be as clear as possible in its actions. The Fed’s past actions have proven that the central bank follows these general guidelines, since the central bank has anchored expectations pretty well (until now).

In the last few years, the Fed has gone through some major changes with Mr. Bernanke at the rudder, and has mostly, managed to break free from the Greenspan era, when market participants focused on how many times the Chairman blinked, or where he looked when he spoke, rather than what he actually said. Mr. Greenspan spoke most of the time in “riddles” that gave some major headaches because the message was never fully understood.

The decisions taken yesterday (to intervene in the debt market without anchoring the market’s expectations first) remind us of the Greenspan era, something that is not very positive from my point of view. Yes, it was a true shock and it had clear effects in the financial markets, but it is still a question of how positive these effects will be in the long-term. If, supposedly, the market/economic conditions continue to deteriorate, the market will expect the Fed to provide another shock. If the FOMC fails to provide it, the financial markets will be very disappointed.

Another problem with the Fed’s statement issued yesterday is that it does not clarify how they have chosen the sums. Why they chose $300 billion for Treasuries, and $750 for mortgages is still unknown, but my guess if that the officials will clarify this at some point in the future, since this is not such a major issue.

The overall conclusion would be that the Fed had communication issues yesterday, and from my point of view took a step backward instead of the forward. Referring to the actual decisions taken yesterday, the markets still need time to clarify how effective they really are.

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U.K. Financial Regulations

Written by A Forex View From Afar on Wednesday, March 18, 2009

The era of “free and unregulated” markets and financial institutions may be over, or at the least, its sunset is quickly approaching as regulators try to avoid further crises in the financial system. The U.K.’s Financial Services Authority released a 122-page report today, which included some of the new rules that will shape the U.K. financial system in the coming years.

The two most important conclusions of the report were that the European Union should form a new regulatory authority, which would supervise the European banking system for systematic risks and exposures. The second important change highlighted in the report is that a clearinghouse should be formed for the mortgage market.

The new regulations package comes as an increasing number of U.K. banks have failed and required to be nationalized by the government, including the biggest national banks. Before the credit crunch, London was seen as the second biggest financial center in the world, closely following New York.

One idea that might prove to be very beneficial for the financial system is that the regulator arm of the law, the FSA, should also regulate financial products and not just financial institutions. This would imply that regulators would have direct access to the investment vehicles that first drove us into the credit crisis, something that might prove to be beneficial over the long term.

Other proposals included in the FSA report suggest that banks should limit their borrowing cap, in an attempt to reduce the likelihood of overleveraging loans, while at the same time, banks should increase the percentage of high-quality assets (theoretically, government issued debts). Among other things, these two decisions would reduce substantially the bank’s profit margin, but it would also increase the overall safety.

However, rules are meant to be broken or at least to search for a way around them. I entirely support stricter rules over the financial markets, but regulators should act preemptively, something that hardly ever happened until now.

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Preparing for the BoJ

Written by A Forex View From Afar on Wednesday, March 18, 2009

Financial markets will be waiting for the Bank of Japan’s (BOJ) press conference during the upcoming Asian session. The press conference follows closely behind the bank’s two day meeting.

The bank’s task will now be to stimulate a falling economy, but without the help of monetary policy. The ultra-low rate of 0.10% stops the BoJ from lowering the interest rate any further, practically putting conventional monetary policy on the sideline. As such, the bank must conceive new ways to stimulate the economy, and help the Japanese financial system. In past meetings, the bank referred to the measures taken as “exceptional for a central bank”

Some of these measures include providing dollar liquidity, intervening in the corporate market, and extending the range of assets accepted as collateral. Additionally, the central bank pledges to buy preferred shares issued by banks, and buying publicly listed shares held on the bank’s balance sheets. However, the last two actions failed because of the Japanese corporate business environment which led to the appearance of zombie banks during Japan’s “lost decade”.

In a new attempt to help the financial system, the BoJ announced that it would provide as much as $10 billion in subordinated debt. Subordinated debt, or junior debt, is among the riskiest forms of lending. In case of a bankruptcy, subordinated debt is the last that gets paid (if funds are still available); on the other hand, senior debt is the first to be paid in case of a bankruptcy.

There have been no further details about the new BoJ plan, but it will most likely be included in the upcoming statement. Chances are that the bank will ask the BoJ staff to analyze the implementation, as has been the case in the past.

The success of the new subordinated lending program is not assured. One reason is that it will hit the same Japanese corporate environment, in which banks refuse any help from the government so as not to affect their reputation. In a time when most of the U.S./European financial systems have survived only by being helped by the government, it is hard to envision any investors actually considering their reputation.
However, past experiences have proved the inflexibility of the Japanese corporate environment, so another failure would not come as a surprise.

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The Chinese Conundrum

Written by A Forex View From Afar on Sunday, March 15, 2009

Before the G20 conference this past weekend, top Chinese officials had complained about the safety of the U.S. Treasuries.

Being by far the largest U.S. bondholder, China has a lot of influence over the debt market. It is said that, the People’s Bank of China holds up to $1 trillion in Treasury notes and government-backed debt, issued by public/private entities like Freddie and Fannie.

It is easy to see why the Chinese government is concerned about the fate of U.S. debt, since such a huge amount of debt holds two major risks: interest rate risk and currency risk. Bonds have a unique relationship between its price and yield, as one rises the other drops. As such, if the yield rises on a bond, its price would fall. Here is where the Fed comes in play.

Eventually, the Fed would have to raise the interest rate, even though this might not happen in the near (or medium) future. A higher interest rate would drag the price of U.S. Treasuries lower, while increasing its yield. From such a move, the Chinese foreign reserves would take a hard hit, because U.S. bonds will lose their value.

Another hit that China might take comes from currency risk. U.S. Treasuries are denominated in dollars, and a steep depreciation of the greenback would pose a huge risk, even though many say the Usd/Cny rate is manipulated.

Neither of these two outcomes are likely to happen in the short term, but as the credit crisis comes to an end and things start to return to normal, money will start pouring out of the U.S. economy in search of higher yields. As such, the dollar and Treasuries will be certain victims, something that should worry the Chinese officials.

Currently, Chinese officials cannot do too much about it, but in time, they will have to begin to diversify from U.S. debt. One of the golden rules of building a successful portfolio is to diversify, something that they have not done, and now the State Administration is paying the price for this. Most analysts say that, President Obama will have a huge problem funding the federal deficit if China was not buying Treasuries.

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Euro-zone rate cuts may be nearing an end

Written by A Forex View From Afar on Tuesday, March 10, 2009

A rather surprising announcement was made today by Mr. Axel Weber, the head of the Bundesbank. The Chairman said at a press conference held in Frankfurt that he sees no need for interest rates to fall below 1%.

Being the largest central bank from the Euro-area and one of the initial founders of the European Central Bank, the Bundesbank certainly has a huge influence over the monetary policy of the ECB. As such, Mr. Weber’s comments can easily be taken as the position of the ECB.

Additionally, the Bundesbank has changed the face of monetary policy by managing to keep inflation down at a time when every major economy in the world had double digit Consumer Price Inflation (CPI). The Bundesbank’s strategy was to anchor expectations by using public speeches and appearances, a strategy that was later used by most central banks to guide expectations (and is still being used).

Over the past few months, ECB officials have repeated that they do not see the need to send the interest rates too low, because it would risk drying up the inter-banking funds. However, this view is not shared by most market participants, who strongly believe that the ECB is way behind the curve on lowering rates.

The main “counterexample” for the ECB’s actions is the Fed, which cut rates as much as it could at a breath-taking pace. The Fed’s view is influenced by a number of academic papers, which say that if the Fed would have cut more in the 1930’s, the U.S. economy may have avoided the Great Depression. This view is strongly supported by Mr. Bernanke, but Nobel winner Paul Krugman has stated lately that this strategy has failed to do anything new. Additionally, the U.S. economy is starting more and more the look like Japan of the 1990’s.

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Can The ECB Cut More Than Expected

Written by A Forex View From Afar on Thursday, March 05, 2009

Tomorrow morning every market participant expects the ECB to reduce the overnight lending rate by 50 basis points, down to 1.50%.

The road to such a low rate was somewhat lengthy for the European Central Bank, compared with the other major central banks, of which almost all are preparing to adopt a quantitative easing strategy.

Until now, the foremost members of the ECB’s voting council have excluded the possibility for very low interest rates. In their opinion, low, real, inter-banking rates would create a liquidity trap, which means that the central bank would reach the limits of monetary policy. At the same time, a liquidity trap would drain any lending in the inter-banking system because of the losses banks would have to take when they borrow or even when they lend. In other words, it would be cheaper for the bank to keep the money for itself than to lend it to another bank, something that has widespread negative effects in the real economy.

For this reason, the Eonia Swap market is pricing in a 0.75% interest rate in the following 3 to 12 months, after which traders expect the bank to begin to slowly raise the key interest rate. Interesting enough, the same Eonia Swap rate, which to some extent is the future market for the ECB rate, began to price in a 1.25% interest rate for tomorrow’s meeting, since the last part of January.

This means that the spread between the forecasted interest rate and the 1-week Eonia Swap rate is -25 basis points, the largest in the current rate cut cycle. This is a sign that prime banks, the ones that trade in the Euro-area inter-banking system, expect the ECB to cut 75 basis points tomorrow. At past meetings, the spread between the two rates was positive.

Also tomorrow, the ECB is expected to update its growth and inflation projections for 2009, also known as the “staff projections”. As has been announced by Mr. Trichet in his speeches, the forecasts will be downgraded considerably from the previous numbers, something that might have a negative effect on the euro’s valuation

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ECB And BOE Face Tough Decisions

Written by A Forex View From Afar on Tuesday, March 03, 2009

Ahead of the interest rate decisions on Thursday from the two major central banks in Europe, the ECB and BoE, the market is looking for a direction where the two might be heading.

In mainland Europe, the ECB’s task is becoming tougher as the credit crunch intensifies, on top of the strong criticism it receives from almost every economist because it reduced the interest rates at too slow a pace.

One of the main concerns of the ECB is to reduce the spread between the German Bunds, which are seen as the safest from the region, and the rest of the member countries, especially Greece, Ireland, Spain and Italy. The ECB cannot intervene directly in the Euro-area debt market, but it can influence the demand and the supply side in the secondary market.

Even though the EU regulations are out of the ECB’s reach, the central bank might get help from them. The European Union treaty forbids any member country to have a budget deficit equal or larger than 3% on the long term. To some extent, this means that the government should follow strict fiscal policies, something that would help bring the yields on the government debt somewhat lower.

Additional help might also come from the European Union to reduce the government yields in Europe. Following a call from Germany last week, today, commissioner Almunia said that the EU would not let down any Eastern European state in case its situation worsens and it will bail it out the country before any international institution will, like the IMF. In the last few weeks, investors grew more nervous about the fate of Eastern Europe.

In the U.K., things are starting to point to the BoE will join the Fed and the BoJ into quantitative easing. Today, the Chancellor of the Exchequer, Alistair Darling, said that the central bank has a green light from the government in expanding its balance sheets. The BoE has the approval to print up to $283 billion that would be used to buy government debt and presumably, some high graded corporate debt. In the two day meeting, the Monetary Policy Committee is expected to announce if this measure was approved, with most market participants saying that this decision would be approved very easily.

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Financials continue to struggle

Written by A Forex View From Afar on Monday, March 02, 2009

The financial stocks continue to drag the major market indexes lower, as their fate becomes more uncertain with each passing day.

Today’s victims in Europe were clearly HSBC and Lloyds, which both lost more than 15%. Lloyds has depreciated about 90% from one year ago, while HSBC lost 44%, a smaller decline because the bank is among the few that still reports profits and refused any government help. In the U.S., Citigroup and Bank of America plunged 20% and 14% respectively today. The selling wave came as AIG received its fourth bailout from the U.S. government. Some of the details from the first three bailouts are still uncertain, and a rising number of analysts say that in this deal profits are privatized while the risks are being nationalized.

AIG’s shares have plunged 99% over the last year going above the borders of bankruptcy, to some extent. However, today, the insurer got a very good deal. It managed to change the conditions on a 40-billion investment made earlier by the Treasury, exchanging preferred shares to non-dividend paying shares. On top of this, the Treasury will buy another $30 billion worth of AIG shares, which will most likely be dividend-free, and shrink some previous credit lines from the Treasury in exchange of some illiquid and most likely worthless assets.

From one point of view, it looks like AIG booked a very good deal today. However, the question that comes to everyone’s mind right now is if this would be the last bailout AIG gets, and how good this deal was for the taxpayers. According to the latest forecasts, the downturn will continue well into the third and the fourth quarters, so it is hard to expect any improvements in the financial markets, something that would eventually really help the banking sector.

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Fundies and Trading
There is a constant question from some traders as to why anybody would ever need to consider the ‘F’ word when trading. Fundamentals: what is so damaging at looking at both Technical charts and having a Fundamental filter to gauge how many Lots to put on? Why is it that accepting that Technicals give us price points to trade, but Fundamentals determine the direction that we travel is so difficult for some traders to accept? Without a Fundamental Filter very few pure Technical traders would have seen this Dollar move coming today.

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