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The economic data flow in Europe has been fairly upbeat of late, with Germany driving European retail sales to a 3.7% gain in January, while German manufacturing and unemployment have also been positive. M3 money supply is also increasing and banks seem to be lending more (as shown in the ECB’s lending survey) and this seems key if Europe is to grow.
The data seems to be providing some backbone to European equities and while the perception of central bank liquidity is helping sentiment, for the first time in years, we are actually seeing positive net EPS revisions. These issues are helping European markets to outperform and should continue to do so for the months to come in my opinion.
European inflation expectations have picked up somewhat of late with the five-year swaps market (the ECB’s preferred measure of inflation expectations) pushing from 1.48% to 1.72% since mid-January. This is probably a function of brent prices finding stability as well, but it highlights that traders could be warming to the idea that the deflationary threat is waning.
Yield spreads driving FX markets
Importantly though, the European bond markets haven’t really responded to the economic data points. This is best measured by looking at yield spreads and the difference between one bond market yield and another. If we are looking specifically at EUR/USD, the two-year US treasury commands an 88 basis point (or 0.88%) premium to the two-year German bund - I have looked at the two-year bond, as it is more sensitive to interest rate expectations. As the US treasury premium increases, so the USD becomes more attractive to investors.
This thematic is unfolding in AUD/USD. The pair are finding buyers, as the premium the Australian two-year treasury holds over US treasuries has increased after the Reserve Bank of Australia meeting. Specifically, we have seen the spread in short-term yields increase to 125 basis points (or 1.25%), from 114bp. If the RBA wants the trade-weighted AUD to fall closer to ‘fair value’ then they really need to drive bond yields lower, as the European Central Bank is doing. What’s occurring here shouldn’t be seen as a currency war; to me this is an interest rate war. Lower bond yields result in a lower currency.
Corporates issuing debt extremely cheaply
In Europe, bond yields are not only negative in the secondary market (where traders freely buy and sell), but we have recently seen Germany and Austria actually issue debt with a negative yield (governments are effectively being paid to borrow money), something many thought they would never see. On the corporate side, French energy giant GDF issued 20-year debt at a coupon (and therefore a yield) of 1.5%, which is amazing in itself for a corporate, while Nestle recently saw its own bonds trade with a negative yield in the secondary market.
It’s not just European companies but globally, corporations have ramped up the levels of debt they have issued in EUR’s. This firmly puts the euro as the markets preferred funding currency for carry trade structures.
The ECB meet tonight and while there will be upgrades to the bank's GDP forecasts (economists are expecting 2015 GDP forecasts to increase 30bp to 1.3%), there will also be some punchy downgrades to their inflation forecasts too. Importantly though, the market is keen to understand the technicalities around its proposed bond buying program. How will they actually achieve the €60 billion a month in public and private bond purchases, in turn expanding its balance by over €1 trillion by September 2016? Will the buyers predominately come from domestic or foreign banks (like we saw when the Federal Reserve started buying its own asset purchase program)? Will they use traditional market markers, or use less conventional avenues, such as reverse auctions in the purchases?
Importantly, the ECB will be buying more European bonds than are being issued by sovereigns as part of their funding requirement. So, in effect we are seeing negative net issuance. By its very nature, this will keep European bond yields low, so in turn we should see US bond yields blow out against European bond markets. The end result should be a weaker euro.
The technical set-up is clearly bearish with EUR/USD breaking through the 2005 and even 2001 uptrends in Q4 2014 and is now eyeing the uptrend drawn from the 1985 low around the parity level. On the daily chart, both trend and momentum oscillators suggest selling rallies with lower levels expected on multiple time frames.