Wednesday 7 August 2019

Why is the Euro rallying on risk off?

Normally in a risk off the USD, TSYs would rally and equities and the Euro would fall. The Yen usually rallies due to capital being repatriated.  

But we have seen in early August that the Euro has rallied on risk off. That can only be flow and position unwind driven.

So which flows and positions are being unwound? Aside from all of the other financial assets like ABS, corp debt, equities, if we just look at Treasuries we might get an answer.

Europe, including the City of London have bought $2.8Tn in Treasuries this cycle, net, plus other US financial assets as part of QE leakage. China and Japan also bought but stopped accumulating TSYs in 2015 and have even cut back on holdings recently.

In this cycle the USD has needed $400-500bn a year to support the CA deficit and the US government has seen debt rise from approximately $10Tn to $22Tn.

So out of the $12Tn rise in US govt debt, these four countries have bought $3.5Tn net and the Fed bought $2.1Tn (from $2.46Tn peak). So QE accounts for $5.6Tn or 46% of the total.

Obviously the higher yields available in US government debt combined with the AAA rating made this attractive to European financials even net of xccy swap basis costs. Unhedged investors have also benefited from the strong USD since 2013.

Unhedged there is a large yield pick up for TSYs. However the flattening of the curve and the fall in yield differentials has made them unattractive or even negatively yielding after xccy swap basis is taken into account.

US 3m Libor is currently 221bps and Euribor is -38.9bps. So a 3 month FX hedge would cost 260bps plus the xccy basis which moves around and I don't have available.

However even if the basis is zero your US 10 yr would yield today 1.63% in USD and that would leave you with -97bps running plus any xccy spread in addition, plus 8 years of interest duration risk vs a 3 month FX hedge. In comparison the Bund is yielding -59bps running and can be repo financed at -47bps (a few months ago the Bund was positively yielding).

As such as risk off hits the markets and TSY yields fall, is it any wonder that European and Japanese investors whether they are FX hedged or not are taking profit and repatriating capital?

So all things being equal this means they sell US TSYs for USD cash and then use that cash to repay any funding/ credit associated with the position such as repo, which is a form of Quantitative Tightening. Similar to the US Treasury rebuilding its cash balances over the next few weeks.  

The USD is also very high on a REER basis causing Trump to loudly complain. Amusingly the Renminbi is the only major that looks more expensive, mainly down to the quasi USD peg. Mexican Peso looks cheap. The French Franc and Deutschmark on a Euro look through basis have also never really been cheaper.

So a Euro rally on risk off is somewhat counter intuitive and you might expect the Euro and Sterling to slide again into Brexit, which is more of a localised story. 

However you will still have this capital repatriation tendency in risk off. Put it another way, the Euro is a now a carry trade funder, same as the Yen.

Another corollary is the Fed will have to cut 100-125bps for 10yr TSYs to have positive carry swapped into Euros. Otherwise they risk forcing the sale of $3.5Tn of them.