Back on March 12, 2015, I added iShares Currency Hedged MSCI Germany ETF (HWG) to my Jubak’s Picks portfolio at a purchase price of $28.11–or at least I thought I did. For reasons that I can’t identify, the buy never made it into the portfolio–although it did get posted on my subscription site JubakAM.com. Today I fixing the omission and entering a buy with my original March 12 price.
Here’s the March 12 post that went with this purchase.
Hedged or unhedged
I’ve spent the week since I wrote http://jubakam.com/2015/03/everything-and-i-mean-everything-you-need-to-know-how-to-invest-in-the-eurozone-now/ on my subscription JubakAM.com site about why putting some money into an ETF focused on a European export-oriented economy such as Germany or Poland was a good way to play the asset purchase program that the European Central Bank announced in detail on Monday, March 9.
I had been inclined to say, “unhedged.” I can easily remember when everything thought the drop in the euro would end at $1.25 or $1.20 or most recently at $1.10 or at parity with the dollar ($1.00.)
The euro closed at $1.0551 today, March 11. If the bottom was $1.00 that was only a further 5.2% drop from here—not a terrible risk—and if the euro were about to rally, then I’d sure like to participate in the bounce.
Now, however, big money managers are talking about this decline in the euro going on into 2017. For example, Deutsche Bank, which was bearish at the euro at the beginning of the year, has gotten even more bearish. The bank is now talking about parity for the euro to the dollar by the end of 2015 and then a continued decline to 85 cents to the euro by 2017.
Yipes. That’s a 19% drop in the euro. Enough of a potential currency loss to wipe out much of any potential gain in share prices.
As of tomorrow March 12 I’m adding iShares Currency Hedged MSCI Germany ETF (HEWG) to my Jubak’s Picks portfolio http://jubakam.com/portfolios/ . (I’m picking this ETF above competitors Wisdom Tree Germany Hedged Equity ETF (DXGE) or Deutsche X-trackers MSCI Germany Hedge Equity ETF (DBGR) because it is about 10 times larger and in this market I’m more comfortable with more liquidity rather than less.) The iShares Hedged Currency MSCI Germany ETF closed at $28.32 on March 11. The expense ratio (with fee waiver) is 0.53% and the ETF yields 1.76%. I calculate a target price of $34 a share by the end of 2015
So why have some big investment houses become so much more negative on the euro lately—and why do I believe them?
It’s a reflection of a deeper study of how the European Central Bank’s program of asset purchases is likely to affect interest rates in the EuroZone. The conclusion is that the plan will send already low rates even lower.
I know that sounds impossible. After all the 2-year German note already yields a negative 0.25% and the 5-year note yields a negative 0.13%.
But it’s not impossible that yields will go lower. It’s actually probable given the structure of the bond market in the EuroZone.
Here’s the problem: Thanks to the EuroZone’s focus on austerity member countries haven’t been issuing much new debt. And they don’t have plans to issue much new debt.
Net issuance of new debt in the EuroZone between now and September 2016—the projected life span of the European Central Bank’s asset purchase program—is projected at just 413 billion euros, according to JPMorgan Chase. I say “just” because the European Central Bank wants to buy 850 billion euros of debt securities. That leaves new supply short of central bank demand by a huge 437 billion euros.
That’s how much the central bank will need to buy in already issued bonds from current owners. To pry them out of the hands of current owners, the European Central Bank will have to offer to pay higher prices—and higher prices translate into lower yields. (Especially since many banks hold these kinds of assets as core parts of a capital bases required by regulators.
The problem will be most acute in the market for German bonds where the bank will be looking to buy 200 billion euros of German government debt and the supply of newly issued debt will be just 6 billion euros during this period.
Getting current bondholders to sell isn’t going to be easy in the case of large institutional holders such as insurance companies and pension funds. These institutions own these bonds because they match projected liabilities in both payout and maturity. Exactly what are these companies supposed to buy to achieve those goals if they do sell their current holdings?
Part of the more negative assessment of the effect of this program of asset purchases on yields and the euro reflects calculations of how quickly asset purchases will reduce the supply of bonds suitable for purchase. The European Central Bank’s plan says that it won’t buy any bond with a negative yield of more than 0.2%. That’s the price that the central bank now charges individual banks to keep deposits in central bank vaults. The negative 0.2% figure is an effort to limit the losses the central bank would take if it buys a bond with a negative yield and yields then wind up climbing. (As they would at some point if this program of asset purchases does indeed increase growth and inflation rates.)
But look how that limit works to reduce supply. Once upon a time—like Tuesday, March 10—the central bank could buy German notes maturing in April 2018, a little more than three years from now. But yields on those notes fell as the price of those notes climbed so that on Tuesday yields fell to a negative 0.23% and these notes were no longer allowable purchases by the central bank.
In effect purchases—or anticipated purchases–by the European Central Bank acted to reduce the supply of bonds available for purchase and to increase the upward pressure on the prices of remaining bonds in the market—with the result that yields on those bonds fell too.
Much of the early worry about this process has focused on the question of whether or not the supply of bonds available for purchase would be exhausted before the program of asset purchases reached an end.
The more recent focus, however, has been on the effect of the asset purchase program on yields now. And the result of this analysis has been to suggest that European bond yields will be in the midst of any even deeper drop just as the U.S. Federal Reserve begins to raise interest rates in June or September.
And that will mean, this analysis says, an even weaker euro than projected earlier.
Of course, there is always the additional possibility that the European Central Bank’s plan won’t work—in which case the central bank will arrive in September 2016 having spent 1 trillion euros on asset purchases with nothing to show for it except deeper negative interest rates on a larger portion of the existing European bond supply.
You can bet the euro would love that.
Call it “Whatever it takes” II.
Today, European Central Bank President Mario Draghi said that the EuroZone central bank “will do what we must to raise inflation as quickly as possible.”
I don’t expect that this promise, made in a speech in Frankfurt, will have the same electric effect as “Whatever it takes” I in July 2012. That promise reversed a plunging euro, pulled the bonds of Spain and Italy back from the brink, and set the stage for a significant recovery in the prices of euro assets.
This time I think the likely market reaction will be positive—that is the euro will move lower as the bank wants (it closed at $1.0656 down 0.68% against the dollar today) and financial assets will move higher (the German DAX is up 0.31% today)—the move will be much more modest. The likely actions from the bank are relatively modest in contrast to past proposals and the problems the central bank faces have proven to be very resistant to the bank’s solutions to date.
After today’s remarks by Draghi pretty much everyone has concluded that the bank will move at its December 3 meeting—even though hardline members of the bank’s board of governors such as Germany’s Jens Weidmann are saying no changes are needed now. The bank’s inflation target of 2% remains a distant dream with the current inflation rate in the EuroZone at just 0.1%.
The policy menu in front of the bank includes an expansion of the current program of bond buying from 60 billion euros a month to 80 billion or so; an extension of the life of the program beyond the current September 2016 limit, and a further drop in the bank deposit rate. In normal times the central bank pays a modest rate of interest on money that banks leave on deposit over night. These days the central bank charges banks that leave their money overnight 0.2%. It’s just about certain that the European Central Bank will take that negative deposit rate even lower to, say a negative 0.3%. Bond yields across the EuroZone are already falling even further into negative territory in anticipation of the central bank’s move. The yield on 2-year German government bonds fell to a record low of a negative 0.389% today.
There is a good possibility that rather than choosing from this policy menu the European Central Bank will implement all of these items. That would still fall well short of a “shock and awe” response to the current mix of extremely low inflation and tepid growth, but at this point it might be the best the European Central Bank can do.
Today Mario Draghi can’t talk the EuroZone up; more stimulus coming in December from European Central Bank
In July 2012 European Central Bank President Mario Draghi talked EuroZone bonds and stocks up by promising to do whatever it took to save the euro.
Today, Draghi’s signal that the European Central Bank would step up stimulus in December couldn’t stem further declines in EuroZone stocks and it didn’t do much for the euro either. The Euro Stoxx 50 index was down 1.78% for the day; the French CAC 40 index was off 1.94%, and the German DAX fell 1.15%.
The euro dropped as low as $1.07 before rallying slightly.
The weakness in the EuroZone extended to U.S. stocks and global commodities The Standard & Poor’s 500 stock index closed down 1.40%. Copper hit its lowest price since 2009.
The iShares MSCI Emerging Markets ETF (EEM) fell another 0.96% bringing its return for the year to a negative 12.79%. Brazil’s real, Colombia’s peso and Russia’s ruble were all down today by at least 1%.
Draghi had said today that downside risks in the EuroZone were “clearly visible” and that the central bank will study increasing the size and duration of its program of quantitative easing at its December meeting. The euro overnight index average has priced in an almost 100% chance of a December cut in European Central Bank deposit rates of at least another 10 basis points. (100 basis points make up 1 percentage point.) That rate, what the central bank pays banks to deposit funds over night, already stands at a negative 20 basis points meaning that banks have to pay the European Central Bank to leave cash on deposit.
With China’s markets on vacation today and tomorrow, you may have a spare neuron or so to devote to this morning’s news from the European Central Bank.
Growth will be slower than expected, the bank said. Inflation may turn negative in 2015. And the bank adjusted some of its rules so that it will be able to complete its full 1.1 trillion euro ($1.2 trillion) program of quantitative easing. Stimulus will continue to September 2016 or beyond, central bank president Mario Draghi said.
European stock markets apparently liked the promise to keep buying bonds and to further depress the euro more than they worried about lower economic growth. The German DAX index closed up 2.66% and the French CAC index was ahead 2.17%. The euro itself closed at $1.1101 after touching a two-week low at $1.1087 during the trading session.
The biggest news in Draghi’s update of the EuroZone’s economic outlook was a forecast that inflation in 2015 would finish, most likely, at an average of 0.1%, and that it might well turn negative for the year. That’s a long way from the central bank’s goal of raising inflation to 2% and leaves the central bank about where it was in the inflation battle when it started its $1.2 billion program of quantitative easing. In what seems to me a transparent effort to put a good face on that inflation news, Draghi pointed out that even if inflation turned negative for 2015, it wouldn’t actually be deflation since the negative effects of lower oil prices are likely to be transitory. For 2016 the bank is predicting an increase in inflation to 1.1% and then to 1.7% in 2017. Do note that even the 1.7% for 2017—two years from now—is below the central bank’s 2% target.
A cheaper euro would ordinarily produce higher economic growth in Europe’s export-oriented economies, such as Germany, Finland, and the Netherlands, as consumers who buy in something other than euros see the price of the goods they purchase fall in their own currencies.
But the euro getting cheaper in dollar terms in a global economy where growth, especially in China is falling, and where we’re on the verge (if we’re not already in the midst of it) of a round of competitive currency devaluations following on China’s recent move.
It’s hard to see how today’s news from the European Central Bank doesn’t lead to even more stimulus from the bank in the not too distant future. And it’s perhaps even harder to see how more stimulus turns the EuroZone into an engine of growth absent an improvement in China’s economy.
Well, that didn’t take long.
Hours after the early Monday morning agreement on an agreement, the plan for a third Greek bailout program and bridge loan had started to come apart. The obstacles could sink the possibility of any deal—if the parties raising a ruckus aren’t willing to compromise.
Perhaps surprisingly given how harsh the agreement to agree is on Greece, the big problems aren’t coming from Athens. It looks like the Greek parliament is set to vote its approval of all the terms creditors demanded before they would sit down at the table to hammer out a bailout program. Prime Minister Alexis Tsipras could well lose a the support of enough of his own Syriza party to force him to form a new coalition government with opposition support, but polls show that 70% of Greeks want parliament to vote yes, and that 68% of voters want Tsipras to stay on as Prime Minister even after any changes to the coalition.
No, the problems are coming from outside Greece—and they’re coming from just about every direction.
A new sustainability report leaked this morning from the International Monetary Fund projecting that the proposal plan will continue to eat away at economic growth in Greece and that Greek debt will peak at 200% of GDP. The report raises the issue of the sustainability of the bailout program. That’s a crucial issue since the IMF is not allowed to extend financing if it doesn’t think it will get the money back. With the 16 billion euros of the 86 billion proposed bailout program projected to come from the IMF, a finding that Greece isn’t sustainable under this plan would blow a huge hole in the agreement to agree. A potential solution would be to provide enough debt relief for Greece that the country’s debt load becomes “sustainable.” That, of course, runs head on into objections from EuroZone governments that oppose any debt relief. Reprofiling—that is extending the term of Greek debt—instead of cutting the amount that Greece owes would require, the IMF projects, extending the maturity of Greek debt for 30 years. Another possible solution would be for some individual country to lend Greece the money it needs for a bridge? Any names spring to mind? (Send suggestions to Alexis Tsipras, Office of the Prime Minister, Athens, Greece.)
The agreement to agree envisions that a short-term bridge loan to let Greece pay the European Central Bank the 3.5 billion euros due on July 20 would come from the European Financial Stability Mechanism set by the European Union in the wake of the global financial crisis. The rules of the EFSM would seem to preclude using the money for EuroZone rescues. The United Kingdom, Denmark, and Sweden, members of the European Union but not of the EuroZone have already objected to this use of EFSM funds.
At least seven other parliaments need to approve the Monday agreement to agree, including Germany, Netherlands, Slovakia, Austria, and Finland. Despite the volume of protest against sending any more money to Greece in Germany, Chancellor Angela Merkel looks like she has the votes to win on the Bundestag on Friday. Finland, however, could throw a spanner in the works. The euro skeptic True Finns party, a member of the current coalition government in Helsinki, opposes extending any more bailout money to Greece and has threatened to bring down the government if it pushes ahead with the plan. Even though the True Finns saw enough success in April elections to increase the party’s clout in government (it’s leader Timo Soini is now foreign minister) I think the party will stop short of fulfilling its threats and there are, unfortunately time-consuming, ways of avoiding any EuroZone country being able to exercise a veto on the bridge loan or final program. The real danger here is that a Finnish “No” would bring out No votes in other EuroZone members such as Slovakia and the Baltic nations.
The problem, in my opinion, isn’t the ultimate approval of a third bailout program—that will eventually get worked out—although I doubt that this program will solve the Greek crisis. And it isn’t the ultimate approval of a bridge loan—that too will get worked out eventually. The issue, though, is whether or not the EuroZone can demonstrate enough near term progress to enable the European Central Bank to keep funding Greek banks and whether or not the EuroZone can work out a bridge loan before the July 20 deadline for Greece to make another payment to the ECB.