The Long Winter

G7 officials used to say that foreign exchange markets should be driven by fundamentals. It struck some as vacuous. What else could drive the largest part of the capital markets, a $6.6 trillion a day turnover prior to the crisis but macro? The challenge is really which macro factors should determine exchange rates.

There seems to a rough consensus of the macroeconomic factors to be included. It is as if the variables of an equation generally agreed, and differences are in the co-efficient or the weighting given to each variable. There is also disagreement about how the variables and coefficients interact with each other. Metrics represent another set of challenges: absolute, or relative, real or nominal. Some data needs to be seasonally-adjusted (e.g., auto sales), while other data (fiscal position) may need to be structurally-adjusted.

All that seems out the window now. Economic data points are interesting to track but have little bearish on what is happening in the capital markets. Everyone recognizes that the business cycle has ended spectacularly, and unlike other downturns in the last 30 years, it did not begin in the financial sector. If data is resilient, like the manufacturing PMIs, it is because of measuring quirk, like delivery times. If the information is poor, like initial claims for unemployment benefits that are available from a few countries (e.g., US, UK, Canada), and the PMI readings, investors know it is likely to get worse.

Here are five things that will be closely watched in the week ahead:

1. Covid-19: Investors and the public are climbing a learning curve in understanding the spread of the virus. It is understood that confirmed cases cannot be understood independently of testing. If testing symptoms and/or hospitalization, there will likely be a high positive ratio, which is not particularly informative by itself. Nor is there an agreed-upon definition of what of a Covid-19 fatality means. Does everyone that passes with the virus die because of the virus? And what of deaths of those that are not tested? It seems too early to make much of differences in patterns between countries, and often it seems the divergence within countries is stark. Moreover, consider the Jia County in China (population circa 640k) had to return to lockdown mode this past week. Some US states, like Florida, Georgia, and Tennessee, have only just begun their shutdowns. By the end of next week, NY state, still the epicenter in the US, is projected to run out of ventilators. Economic models that assumed that the shutdowns would end in April may have to be re-thought, and several European countries have already done so. Apple says its US store may not open until mid-May. 

2. Europe’s Response: While European countries are responding, and the ECB has responded boldly, Europe has not. The issue will come to a head next week as the Eurogroup of EMU finance ministers is to present the heads of state with a set of options to help manage the fiscal consequences of the war against Covid-19. The key divide in Europe remains between the creditors and debtors, and the critical issue is how and by how much the costs should be shared.  Many of the same people and countries that advocated a common bond in the 2010 sovereign crisis have resurrected many of their arguments, including claims of the demise of Europe without it. And despite arguments about the similarity of the crisis with the GFC, the key difference also bolsters the case for a common bond:  There is no moral hazard. Yet the creditors are pushing back against a corona bond. The significant debt burdens and the absence of sufficient structural reforms (the other half of Draghi’s willingness “to do whatever it takes”)  and the lack of political stability among several of the large debtors, including Italy, puts the creditors off. They appear willing to repurpose the European Stabilization Mechanism that has over 400 bln euro of lending capacity, into a light-conditionality loan facility. Yet, if some members do not draw on their lines, there will be a stigma for those that do. A new collective bond also raises issues about seniority and subordinates existing private creditors.

The French have the most ambitious plan for Europe that includes a large bond offering (5-10 years) to help finance health expenditures, including new healthcare capacity, and partly funded by a solidarity tax.  It has other essential elements, like a moratorium on debt payments owed to the Paris Club, a  new SDR offering for developing countries, and foreign exchange swap lines. There has been some criticism of the ECB during the GFC for not offering fx swap lines to eastern and central Europe. It would be interesting to see if such action spurs China to offer similar debt relief to those participating in the Belt Road Initiative. It would not set right if the Paris Club moratorium was used by some to service their Chinese debt. German Finance Minister Scholz suggested a 200 bln euro ESM facility for which half would be earmarked for Italy.

3. Oil: This has been another historic collapse of oil prices. Oversupply before the onset of the virus has now become a deluge.  One producer in the US paid another company to remove its oil derivative used for asphalt, a negative rate for oil.  Previously, the US called on the Saudis to allow lower prices, and now prices are too low. The price for May WTI was hovering near $20 a barrel when Trump claimed he successfully negotiated with Russia and Saudi Arabia to reduce output.  The virtual meeting among OPEC and other oil producers that was scheduled for April 7 now looks to be postponed a day or two to extend the negotiations.  Ostensibly, this would be seen as a constructive development. Yet, at the White House meeting between the President and oil producers, the possibility of putting tariffs on Saudi oil imports as a way of boosting prices was discussed, according to reports.  

It is difficult for the US to be critical of the cartel, including threats of legal action, and then call on it to become a stronger cartel by coordinating a production cut.  It even harder to see the US formally cooperating with a production cut on both ideological and practical grounds (highly decentralized shale production).  That said, weak prices and rising storage costs, i.e., market pressures, are forcing several US producers to cut back.  Baker Hughes estimates 31 rigs were idled in the Permian region last week. In the past three weeks, 16% of the region’s rigs have been idled. New Mexican producers will be allowed to reduce output from state-owned lands for at least 30 days and could be extended to 120 days. Estimates suggest 33%-40% of New Mexico’s share of the Permian Basin production is from state-owned land. Oklahoma and Texas may also consider a reduction in output. 

4.  Negative Rates: The Federal Reserve’s response to the crisis has been in three-dimensions. The first is monetary policy proper, and that is the rate cuts and the now open-ended asset purchases. The second dimension is the different facilities to support different parts of the capital markets. The Fed established special investment vehicles, seeded with funds (Exchange Stabilization Funds) from the Treasury Department, and leverages it to buy commercial paper, corporate bonds, municipal bonds, asset-backed securities, and soon loans to small and medium-sized businesses.  The swaps and repo lines with foreign central banks are efforts to promote the stability of the capital markets.  The third dimension is the regulatory forbearance that is also being brought to bear, such as last week’s decision to ease the liquidity ratio rules. Some observers see these measures as ultimately leading to negative rates in the US.  There are a little more than $10 trillion of negative-yielding bonds.  So far, only countries with negative policy rates have negative market rates.  And the only countries to have gone through the zero-bound have enjoyed a savings surplus (= current account surplus).

Sweden, rather than the US, may challenge this induction.  At the end of last year, the Riksbank lifted its repo rate to zero.  Yet the curve, from the three-month bill (-15 bp) to the 10-year bond (-18 bp) offer negative yields.  However, the deposit rate is negative 10 bp.   Some US T-bill yields had slipped into negative territory, but heavy supply and less volatile markets have seen yields rise.  The six-month yield is above the 10 bp interest on reserves.  This does not mean that the two-year US yield cannot fall to similar levels.  The UK two-year yield is at eight basis points. 

5.  FX: The foreign exchange market remains volatile and streaky. Three-month implied volatility for the major currencies is roughly twice what it was in early February. What stands out in recent days has been the weakness of the euro, which also is the key driver of the Dollar Index.  In the euro was the weakest of the major currencies, falling nearly 3% against the dollar.  The extreme premium for US dollars funding evident in the three-month cross-currency basis swaps has been fully resolved and then some.  In fact, the premium for the euro is at record highs, rising every day last week from about 25 bp to around 65 bp, and yet the euro fell every session last week. The premium for  sterling rose to what appear to be new record highs above 40 bp (from 27 bp the previous week). The yen was still at a discount a week ago (-43 bp) and now stands near 34 bp. To put this in perspective, the yen premium is the first in eight years. The Canadian dollar is still at a discount, but the discount has been reduced from -70 bp in mid-March to -14 bp now, and the Bank of Canada has yet to tap its swap lines with the Fed. Meanwhile, the OIS/LIBOR spread remains extreme and shows that the onshore-offshore lending remains dysfunctional. And it is this discrepancy that may help explain why the cross-currency basis swaps look so distorted now. 

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