Last week, we showed a curious thesis by Goldman, which asked if there is a new and “ominous” development in European currency swings, namely the emergence of what may be a “under the table” fight between the ECB and the Bundesbank on which bonds to monetize.
This is what Goldman said then:
the average maturity of ECB bond buying is around 8.0 years, in line with what Executive Board member Coeure said in his May 18 speech. However, while Italy and Spain see purchases that have an average maturity above that of the outstanding debt stock, Bundesbank buying has fallen short from the very beginning…. This kind of signal – from the key hawk in the Eurosystem – has the potential to undercut the credibility of ECB QE, since it weakens the portfolio balance channel.
After all, it was supposed to be low yields in core Europe into risk assets. If those yields now rise and become more volatile, such portfolio effects will be lessened.
Today, in a follow up report by Goldman’s Robin Brooks and company, and one which seeks to validate Goldman’s “top trade” thesis of a weak Euro currency, (recall Goldman top trade #1 for 2015: “Stay long EUR/$ downside via 1-year 1.00/0.95 put spread (originally at 1.20/1.15 with a premium of 70bp EUR at initiation, expiring on 20 Nov 2015, opened at a spot EUR/$ of 1.253 on 20 Nov 2014, currently at 1.135.”) Goldman explains why despite relentless Greek drama, the EUR hasn’t moved and its conclusion is that this is due to “growing question marks over ECB QE” as a result of the surprising bond-buying on the short end (at the expense of reducing longer-term maturity holdings) out of the Bundesbank which has “reduced the maturity of its QE buying.”
As tensions around Greece have mounted, it is something of a puzzle that EUR/$ has shown little reaction. Our explanation, laid out in our last FX Views, is that much of this price action stems from the Bundesbank, which has reduced the maturity of its QE buying, enabling the Bund sell-off and moving longer-dated rate differentials in favor of the Euro. EUR/$ thus hasn’t traded Greece, but instead growing question marks over ECB QE.
Here is Goldman’s full take:
From an economic perspective, Greece shows that “internal devaluation” – whereby structural reforms are meant to restore competitiveness and growth –is difficult politically and a poor substitute for outright devaluation. Emerging markets that devalue during crises quickly return to growth, powered by exports, while Greek GDP continues to languish. We emphasize this because – even if a compromise involving a debt haircut is found – this will not do much to return Greece to growth. Only a managed devaluation, with the help of the creditors, can do that. With respect to EUR/$, we think the Bund sell-off increases EUR/$ downside if tensions over Greece escalate further. This is because the ECB, including via the Bundesbank, would almost surely step up QE to prevent contagion. We estimate that the immediate aftermath of a default could see EUR/$ fall three big figures. The ensuing acceleration in QE would then take EUR/$ down another seven big figures in subsequent weeks. We thus see Greece as a catalyst for EUR/$ to go near parity, via stepped up QE that moves rate differentials against the single currency.
Incidentally, “internal devaluation” is a very polite way of saying plunging wages, labor costs, and generally benefits, including pensions.
But if this is correct, Goldman essentially says that it is in the ECB’s, and Europe’s, best interest to have a Greek default – and with limited contagion at that – one which finally does impact the EUR lower, and resumes the “benign” glideslope of the EURUSD exchange rate toward parity, a rate which recall reached as low as 1.05 several months ago before rebounding to its current level of 1.14. Needless to say, that is a “conspiracy theory” that could make even the biggest “tin foil” blogs blush.
A different way of saying what Goldman just hinted at: “Greece must be destroyed, so it (and the Eurozone) can be saved (with even more QE).”
Or, in the parlance of Rahm Emanuel’s times, “Let no Greek default crisis go to QE wastel.”
Greece, like many emerging markets before it, is suffering a balance of payments crisis, whereby a “sudden stop” in foreign capital inflows caused GDP to fall sharply. In emerging markets, this comes with a large upfront currency devaluation – on average around 30 percent across nine key episodes (Exhibit 1) – that lasts for over four years. This devaluation boosts exports, so that – as unpleasant as this phase of the crisis is – activity rebounds quickly and GDP is significantly above pre-crisis levels five years on (Exhibit 2). In Greece, although unit labor costs have fallen significantly, price competitiveness has improved much less, with the real effective exchange rate down only ten percent (with much of that drop only coming recently). This shows that the process of “internal devaluation” is difficult and, unfortunately, a poor substitute for outright devaluation. The reason we emphasize this is because, even if a compromise is found that includes a debt write-down (as the Greek government is pushing for), this will do little to return Greece to growth. Only a managed devaluation can do that, one where the creditors continue to lend and help manage the transition.
Here, Goldman does something shocking – it tells the truth! “As such, the current stand-off is about something much deeper than the next disbursement. It signals that the concept of “internal devaluation” is deeply troubled.”
Bingo – because what Goldman just said in a very polite way, is that a monetary union in which one of the nations is as far behind as Greece is, and recall just how far behind Greece is relative to IMF GDP estimates imposed during the prior two bailouts…
… simply does not work, and for the union to be viable, a stressor needs to emerge so that broad currency devaluation benefits not only the peak performers, i.e., the northern European states, but the weakest links such as Greece.
Incidentally, all of this was previewed long ago in, in December 2012 when we wrote “Next Up For A “Recovering” Europe: A 30-50% Collapse In Wages In Spain, Italy And… France.” To Greece’s great chagrin, all of this internal devaluation has mostly impacted the impoverished country, which continues to be a shock absorber to broader internal devaluation across the entire Eurozone.
Which brings us back to Goldman’s assessment of the current Greek state, and the suggestion that all the smoke and mirrors flooding the headline-scanning algos is nothing but noise, and that in reality the forces are alligned to “push the EUR near parity in fairly short order.”
Paradoxically, Goldman keeps pushing for a worst-case outcome, and one where the market finally reprices all the risk it has ignored for months:
Even if Greece ultimately stays in the Euro (our base case), the immediate aftermath of such a non-payment will be to push bond yields up across the periphery. This rise in the fiscal risk premium (Exhibit 3) will of course be limited, because the ECB will likely accelerate QE, including via the Bundesbank. That will push rate differentials, especially longer-dated ones (Exhibit 4), against EUR/$. We estimate that the initial fiscal risk premium effect could be three big figures, while the subsequent QE effect could be worth around seven big figures.
In short, we see mounting tensions over Greece as a catalyst for EUR/$ to move near parity in fairly short order, with much of that move driven by rate differentials. If, instead, a compromise solution is found (including possible debt haircuts), we see the upside to EUR/$ as very limited, i.e. on the order of one big figure at most. The reason for this is that the market is broadly expecting an agreement to be found, even with the possibility of a default in the near term on debt repayments coming due.
And of course, going back to the start of the note, a “favorable” outcome pushing EUR higher will be one that “will do little to return Greece to growth” and as a result will force the insolvent nation back to the negotiating table until such time as the Eurozone finally realizes that it desperately needs EUR much lower, not higher, and will do everything it can to achieve that, even if it means “siloing” Greece in a state of suspended default indefinitely if only to eliminate the “risk on” euphoria in the currency pair.
Indeed, as we said last year, the entire escalation over the Ukraine conflict was merely to push Europe to the verge of a triple-dip recession, which in turn was the catalyst that finally greenlighted the ECB’s first episode of QE with Buba’s blessing (after all Germany’s economy was finally on the brink as well and it had little to lose). Well, the next such “catalyst” will come from none other than Greece as per Goldman’s punchline:
We encounter many who argue that mounting tensions over Greece could be Euro positive. The short term angle is that risk reduction will lead to a squeeze of Euro shorts, so that EUR/$ could squeeze higher. The reason we don’t believe this is because we think stepped up ECB QE will dominate any risk-off response. Or, to put this in another way, the ECB will not allow the fiscal risk premium to go all that much higher. The medium-term angle is that the Euro zone might be more cohesive without Greece. That rationale assumes that Greece is a case apart, when of course it isn’t. After all, the Spanish unemployment rate is not far behind that of Greece and populist political pressure is also building. The underlying commonality, in our minds, is that “internal devaluation” is very difficult. As a result, we think mounting tensions around Greece could just as well focus market attention on the sustainability of the adjustment program on the Euro periphery.
Whoever would have thought that none other than Goldman would serve as the source of what may be the biggest “conspiracy theory” gambit of 2015…
One final thought: what Goldman wants, its former employee at the ECB tends to deliver.