Threat of Deflation sends Euro to Three Week Lows

By: Marc to Market

The main impulse, today, is the heightened deflationary risk in the euro area, sparked by Spanish and German state inflation figures.  The euro area's flash CPI will be reported Monday ahead of next Thursday's ECB meeting.  

Since Draghi's comments that recognized that the euro's strength, while not a target of policy directly, was becoming a risk to the growth and inflation goals of the central bank, and Bundesbank President Weidmann apparently dropping his opposition to QE (in theory), the euro has slowly surrendering the gains scored in response to the do-nothing ECB meeting.

Spain reported a 0.2% decline in the preliminary reading of March CPI.  The market has expected an unchanged reading of 0.1% for the EU harmonized measure.   It is the lowest since Oct 2009.  In the euro-area measure, Spain is about 1/8.  However, the German states that have reported suggest slippage in the national estimate that will be reported in the North American morning.  The harmonized measure may ease below 1.0%.

Adding insult to injury, the real sector data has disappointed, as well.  Spanish retail sales recovered strongly last year.  Retail sales were contracted at an almost 12% year-over-year pace at the end of 2012.  In  September, it was rising a little more than 2%.  In February, it fell 0.5% after a 0.5% gain in January.

The French disappointment was just as disturbing.  Following news earlier this week of a further rise in unemployment, today France reported a 0.3% fall in February consumer spending on a year-over-year basis.  The Bloomberg consensus expected a 0.7% gain.  On the month, sales rose 0.1%, not 0.8% as was expected.

The net effect has been to boost expectations for ECB action next week.  The 1-year/1-year EONIA rate, which has become a popular way to gauge expectations, is falling today, as it has each day this week, for its longest streak in a year.  It stands at a 2-week low near 18 bp.   The heightened risks that the ECB responds come at the same time the rise in short-term US rates, sparked by the FOMC and Yellen's comments have not been reversed.  

This has sent the US-German 2-year spread above 30 bp, the highest since mid-2012 (~33 bp), which is essentially the high since the crisis.  Although it the relationship had broken down, over the long-term, we find it have been a useful guide.   Perhaps the fact that both sides are moving in opposite directions and the sheer magnitude is going to pull the euro back into its orbit.

At the same time, the LTRO payment announcement today will be closely watched.  Banks have stepped up their payments in recent weeks, and very little appears to have been rolled into the main repo operations.  Banks have paid down about 40 bln euro sin the past three week.  Excess liquidity in has fallen below 105 bln euros, which represents a new low since the LTRO's.

After taking out the FOMC low (~$1.3750) in North America yesterday, the soft data allowed European participants push through the door that was already open.  The euro found a bid ahead of $1.3700.  A break of there could set up a quick move toward the $1.3640-50 area.   The short-term speculative market has been accumulating a significant long euro position.  

In the futures market, the gross long position has risen consistently from about 67.6k contracted in early February to 118k contracts as of March 18.  The cost of holding euro positions has increased (interest rate differential) and the risk of ECB action next week has increased.   Late longs are in weak hands and we suspect that money management discipline is flushing out some of these.    However, many economists and analysts are warning of disappointment with the ECB, in which case the euro would likely recover by the end of next week.

Separately, the other theme that has emerged this week is the strength of the dollar-bloc currencies.  They are easily the strongest of the majors this week with 1.8%-2.0% gains and the Aussie leading the way.    It reached almost $0.9300 in Asia before pulling back.  The pullback has been shallow and we suspect the market is not down yet and will push toward $0.9340 and possibly $0.9400.   The technical trade idea suggested yesterday, the head and shoulders pattern in the euro against the Australian dollar, has continued to unfold.   Recall the key break was at A$1.50 and the measuring objective is A$1.42, with the initial target near A$1.4730.   It tested A$1.4780 today.

The New Zealand dollar is also extending its gains and approached $0.8700 today, a new 3-year high.  It finished 2013 near $0.8200.  It is the strongest major currency this quarter, gaining 5.8%.  On the other hand, the Canadian dollar is the second strongest currency this week, but is the weakest on the quarter, losing about 3.5%.  The US dollar is finding support near CAD1.10, but there too the market does not seem to have finished washing out the weak positions.    There has been a large rise in short Canadian dollar futures positions, in recent weeks.

The US reports February personal income and consumption and the University of Michigan consumer confidence.  These are not typically market movers.  The Fed's George, a hawk, speaks, and this means no push against Yellen's 6-month framework.    Lastly, we note that one mystery has deepened.  Yesterday the Fed reported its custody holdings jumped $54.2 bln.  This is the second large rise in a row for a combined $88.5 bln, after falling $104.5 bln in the previous week. 

Russia and the Birth of the Eurodollar Market

By Marc to Market

Talk that Russia could be behind the bulk of the more than $100 bln drop in the Federal Reserve's custody holdings for foreign central banks, in the week ending Wednesday has many observers scratching their heads. This could represent about 75% of their Treasury bond holdings according December Treasury data.  

As we noted earlier, rather than selling the Treasuries, Russia probably simply transferred them from the Federal Reserve out of the US. The motivation would be the threat of sanctions following this week's Crimean referendum.

There is precedent for this kind of behavior from Russia. Recall the origins of the Eurodollar market. The Eurodollar market has nothing to do the European Economic and Monetary Union (EMU) or the euro itself. Rather the Eurodollar market refers to dollars outside the US, initially Europe.

In 1956, the US and Soviet Union opposed British and French (and Israeli) invasion of Egypt (Suez Crisis). The US threatened to sell British pounds and intensify the pressure it was already experiencing in maintaining it peg to the dollar under Bretton Woods. It also threatened to veto the UK 's request for a large IMF assistance package. Russia witnessed the US willingness to use its financial acumen to impose its will on its special ally.

At roughly the same time, a reformist government came to power in the Hungary and among other things tried to leave the Warsaw Pact. The Soviet Union invaded. Russia feared that the US would use its financial superiority against it in protest. In 1957, Russia-based Narodny Bank shifted dollars from the US and deposited them in its branch in London. Voila, the birth of the Eurodollar market.

There were other advantages of this offshore market for US dollars beyond the Soviet Union's intentions. Those dollars were not subject to US interest rate cap or regulations. These dollars, as we know with the benefit of hindsight, became the basis for a new bank credit, and a critical part of international finance.

The logic now is that Russia is bracing for the next round of sanctions. The US and Europe are reluctant to confront Russia militarily. US and Europe did not confront Russia militarily after the Soviet Union invaded Hungary or Czechoslovakia, and it wasn't that Eisenhower or Johnson (the respective presidents at the time) were weak as some claim about Obama. Nor did President Bush confront Russia with arms when it invaded and continued to occupy parts of Georgia in 2008.

To be sure, the Federal Reserve does not publish the client list of who uses its custodial services. As we noted, some suggest it could be China diversifying reserves out of dollars and ostensibly into euros, which would help explain the persistent euro strength. However, we are a bit more skeptical of China in that it has a lot on its plate presently. The timing of the drop in custody holdings makes Russia a more likely suspect. The intervention by emerging market central banks, including Russia, seem far too small to account for $100 bln+ move in a week.