Reassessment of Euro Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

The Euro rebound is stronger than anticipated as investors and central banks show an increased appetite for euro denominated paper as signs of a Greek debt crisis start to fade.  The rise in oil prices and surge in central bank reserves has triggered the demand for currency diversification. The euro is one of the few safe currencies that can absorb the growth of reserves.  As we have noted in our blogs of Feb. 26^th and Feb. 15^th, USD or Canadian dollar based investors may want to hedge potential euro exposure.

 

Analysts expect the demand for euro denominated assets to persist temporarily as oil prices remain elevated and central banks, especially in emerging markets, continue to diversify reserves.  This temporary demand for euro denominated may receive temporary support from political tensions in the Middle East and the false sense that problems in the euro peripheral countries have been resolved.  Longer-term, the risks to the euro remain to the downside as the sovereign debt crisis has evolved into a banking crisis and projected economic stagnation in Europe relative to the rest of the world.

 

Spreads on sovereign debt declined since the proposed settlement for Greece was reached.  There is a link between the decline in bond spreads and the ECB announcement the creation of the long-term refinancing operations (LTROs).  There is concern that banks will borrow from the ECB at low rates and buy sovereign bonds whose yields are higher, especially where banks are subject to local political pressure.  Policymakers realize that one of the necessary conditions to stabilize financial markets was the need for an explicit guarantee (such as the ECB) for sovereign debt.    

 

However, this move along with the other temporary financing facilities falls short of what is needed.  Greece and Portugal will not be able to grow with their existing debt burdens.  This could result in contagion spreading to Italy and elsewhere.  European growth is projected to be flat to negative for 2012 and only a modest in 2013, especially with significant budget cuts.

 

The temporary financing could make things more dangerous.  Any wave of sovereign defaults would create problems for the ECB as nearly euro one trillion in sovereign debt is due for rollover in the next 12 months.  The sale of overseas assets by European financial institutions to bolster capital and continued reduction of sovereign exposure by private investors could add to euro pressure.  European politicians have failed to address any of the underlying long-term structural issues facing euro such as monitoring and implementing policies deficit reduction among member states.

Foreign Exchange Risk for 2012

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

  

As we enter 2012, the euro has emerged as the weakest currency against the US dollar among the major currencies.   Investors still continue to short the euro on expectations the currency move lower is not finished.  This view is based on the ECB facility is a stop-gap measure and does not resolve the solvency issues.  Investors note the following: the Greece refinancing led by the IMF is still not functioning as expected, the cost of Italian and Spanish debt still remains around 7%, European banks are having a difficult time raising new capital and real investors lack additional appetite for further euro risk exposure.

 

Global economic indicators have started to improve, especially in the US.  However, the demand for European risk assets remains weak as the focus remains on a potential recession and contagion impact to the global economy.  Previously in 2011, anytime the euro came under pressure it was often followed by a countertrend rally.  However, 2012 could be different as real non-European investors continue reducing their euro sovereign bond exposures.  The supply surge of sovereign debt, euro $1 - 1.2 trillion, coming to the market in 2012 and the rollover, euro 700-800 billion, of bank paper/new capital could cause digestion problems as global investors to reduce European exposure.

 

In 2011, the US dollar was used as the funding currency for risky assets.  Given the prospect of a European recession, will cause the ECB to further cut rates and keep them low for an extended period.  The poor reception of capital market issues of European banks suggests that further balance sheet contraction is needed to meet the higher capital ratios.  Banks continue to place funds with the ECB and not employing the central bank liquidity in the real economy.  Real yields have moved into negative territory as the ECB tries to promote an investor shift into riskier assets.  The problem is that the time lag between liquidity creation and a move into risky assets has a time lag.  However, the uncertain outlook suggests this delay may take an extended period of time.

 

The use of the euro as a funding currency rather than an asset currency, a prolonged period of low ECB rates, the prospect of a European recession and uncertainty from the overhang of sovereign/bank debt will push the euro lower.  There will be limited countercyclical euro rallies compared to 2011.  The euro downtrend should continue through the summer until either political gridlock in Washington grabs investor attention as the November election approaches and/or policymakers can provide a resolution for the sovereign debt/banking crisis in Europe.   

Euro Outlook: Fundamentals versus Market Sentiment

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The euro has rallied against the US dollar last week ending the week just below 1.39.  This rally does not appear related to yield differentials.  Current Euro-US short-dated bond rate differentials would suggest a weaker euro against the dollar.  Economic fundamentals and market sentiment are clearly out of line and pose potential currency risks.

Bond investments tend to be one of the largest cross border flows.  Any divergence between currency values and rate differentials suggests that decisions to buy and sell currencies may be related to other factors.  It is possible that as European banks may be repatriating funds in anticipation of reducing their balance sheets.  The rising losses on Greek sovereign debt and bank share trading below book value limit flexibility in raising funds from private investors. This suggests that shrinking the balance as one method to meet capital requirements.

When banks start a deleveraging process, the first adjustment is made to overseas business that is considered non-essential.  A second adjustment may occur when banks attempt to reduce their short-term funding requirements, especially in non-core currency markets away from the euro.  In particular, this could impact trade finance and commodity finance where European banks are major players.

The fact that the euro/dollar is not trading in line with rate differentials suggest other factors may be supporting the euro.  This has allowed the euro to withstand selling pressure against the dollar.  This may allow the euro to be well supported against the dollar as long as repatriation flows continue.  As banks reduce their balance sheets, the impact is deflationary for markets and negative for asset prices.  The impact of European bank deleveraging and potential credit rationing could have a strong impact on European growth prospects.

Therefore, the prospect of weaker growth prospects and the gradual ending of financial institutions repatriation could spell weakness for the euro as economic fundamentals start to reassert themselves.  What is your hedging strategy?  

Wobbly dollar …. wobbly America

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Forget Greece, Portugal, Ireland and Spain for a moment.  Reuters[1] reports that the United Nations warns of a possible collapse of the U.S. dollar.  No wonder!  And no wonder S&P placed a negative outlook on U.S. government debt!  Such public utterances were inconceivable in the very recent past, which indicates just how fast things seem to have got out of hand.  The U.S. has hit its $14.3 trillion federal debt ceiling (close to 100% of GDP and close to post second world war levels) and there is now a game of political chicken going on.  Some accounting contortions are allowing ongoing funding of expenditures but this can only be very temporary.

 

The level of spending cuts being mentioned falls far short of dealing with the deficit, let alone the gargantuan mountain of debt.  Meaningful tax increases don’t seem to be on the table.  Add to this debt at State and municipal level, the demographic time bomb of pension and health care liabilities, etc., and we have the script for a disaster movie.  With debt at existing levels, even tiny increases in interest rates will lead to huge increases in interest expense.  Currently, U.S debt yields are slightly above those of Germany.  However, the more scare stories there are, the more this gap is likely to rise.  Canada fell into this trap in the early 1990’s when it found out just how insidious compound interest is – spending cuts were more than offset by year over year increases in interest spending.  And the latter cannot be cut.  The more it rises, the more spending elsewhere must be cut and the fewer options are available.

 

Unfortunately, due to the staggering size of the problem, it has the potential to affect almost everyone on the planet but most of us can only look on with astonishment.  We don’t have a say in any of this.  Foreign currency exchange rates and interest rates have the potential to be very volatile for some time to come.

 

There is not a lot that we as individuals or companies can do but there are some things.  Companies should urgently re-evaluate their foreign currency exposures, even if they have done so recently, and revisit governance and risk management strategies for hedging and mitigating such exposures.  They should also examine current and future interest rate / capital structures.  It is imperative to have strong handle on these risk exposures and perform extreme scenario analysis.

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[1] www.reuters.com/article/2011/05/25/economy-un-idUSN2511223620110525

China’s energy needs = America’s sacrifice

by Michael Arbow, MBA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Over the past two months the markets have witnessed rising oil prices and a quick snap correction.  The culprit cited for the rise is unrest in the Middle East (still unresolved) and for the fall a slowing of the US economy.  These are immediate term issues which will eventually fade in the wash of time and are only masking the continued upward movement of oil due to a world which if not at peak oil then is at least increasing reserves at a rate less than usage increases.  Surrounding this news is China, a growing economy that requires only a 1% increase in oil demand to wipe-out a 10% decrease in US use.  So how will China get the oil it needs to continue growing? 

 

The idea sported by Jeff Rubin (see link) suggest that the Chinese slow down on their uptake of US government debt.  By doing this the US government has two options either a) print money and thus debase the dollar and therefore raise the US dollar price for oil/gasoline or b) reduce the government debt which in itself will either cause the economy to slow and/or US consumers to be taxed more and thus less able to afford gasoline (already on average 9% of US disposable income up from 5% two years ago).

 

Either solution will result in a weaker US dollar relative to most currencies and an economy that can no longer afford some of imported luxuries.  The risk questions that arise from this scenario are numerous and can only be reduced by some positive US Black Swan event (?).  I believe the path has been decided it is only the knowledge of the timing that remains elusive.  In this volatile global village even smaller local firms can be take a “hit”.  How is your risk team looking at this eventuality?  Or is it still too far out there to consider? 

 

For more on Jeff Rubin’s views on this click on the Globe and Mail link:

http://tinyurl.com/3l9fkg6

Well that was fun,… for some: Canada’s election results

by Michael Arbow, MBA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

May 2^nd was a rather busy day for the global news junkie but here in Canada, international events took a back seat to the Federal election.  What started as a snooze fest was anything but in the last two weeks of campaigning and provided political risk managers – spin doctors (?) with some valuable lessons.  The end result was the Conservative Party received a majority government after three tries, the number three (New Democratic Party) unexpectedly become the number two and the nation’s number two, the Liberals may be going the way of the 1935 British Liberal party.  A special mention should also go out to the Bloc Quebecois which enjoyed one generation of staying power and was wiped out – perhaps joining the Liberal party in the history books.

 

A week after the fact and the dust has settled, a clearer picture of where that leaves Canada’s people and organizations is beginning to emerge.  With a strong left wing opposition, expect the right wing Conservatives to move a little closer to the centre on some issues, but fundamental to the Conservatives is low corporate and personal taxes and continued support for the energy sector (read; oil sands) and possibly agriculture.  Also expect the Conservatives to push for a national securities regulator and be pretty hands-off on the financial and greater business community.  End result: the Canadian dollar will continue to strengthen against the US dollar and likely most OECD currencies.  Expectations for yearend are already $USD 1.09 (CAD .92/1.00 USD) and I can see Patricia Croft’s and David Rosenberg’s three year expectation of $1.20 still a possibility.

 

So the story of the loonie’s rise continues and if anything is now reinforced.  For Canadian exporters, the argument for delaying effective hedge strategies is continuing to get weaker.  The question then is:  what discussions does your risk department have prior to and after an election?  Canada has shown, the unexpected can happen and the results can be significant. 

 

For more on this story click on the link to the Globe and Mail article:

http://tinyurl.com/4xo2jct

 

You aint seen nothin’ yet ….

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

So the U.S. government didn’t shut down thanks to an agreement to cut an extra $38 billion of spending (compared with deficit of around $1.4 trillion).  We’ve been here before and life has always gone on.  However, perhaps a more frightening situation is coming up.  The U.S. is about to hit its legal debt ceiling of $14.3 trillion which is getting on towards 100% of GDP.  These numbers just beggar belief.  The U.S. is now the only major economy with such debt and deficit problems that has not introduced some sort of realistic austerity program so the situation keeps getting worse.  Other stats can be quoted that compound the grief – or determination to act – that perhaps should be felt. 

Of course, we’re constantly told that the U.S. is different.  The economy has unequalled potential, it always grows, foreign investors hold so much U.S. debt that if they didn’t keep buying it, their investment would lose value, etc., etc. 

Nobody expects a U.S. debt default but more and more people mention the possibility before coming up with the aforementioned reasons why it will not happen.  But, surely the party cannot go on forever.  Something has to give and with the American form of dysfunctional government, it may take some external event or shock to cause the very painful action required. 

This of course would affect, not only the U.S. dollar but many, if not all other currencies in terms of volatility.  I will leave open the question of: what should companies be doing?  As a partial answer, companies should be thinking very seriously about various scenarios.  They should know and understand their currency and interest rate exposures in a far more detailed, scientific and meaningful way than the traditional “have a handle in my head” of the CFO’s and treasures of many businesses. 

I will expand on this in coming blogs but it would be interesting to have some discussion of how big an issue others see this as being.

The Loonie: A new safe haven currency

by Michael Arbow MBA

Partner, RSD Solutions Inc.

www.rsdsolutions.com

info@rsdsolutions.com

 

The past few weeks have been filled with world altering events and uncertainty and the end story for those in Japan, much of the Middle East and the Euro-zone has yet to be written. With uncertainty, the appreciation in the price of gold has happened and is expected but what is not expected is an unwavering Canadian dollar (CAD). In terms of world currencies, when the going gets tough, generally, the tough go the US dollar (USD). However since February 1^st the CAD has traded above par to the USD and that is with long Canadian government interest rates at 80 basis points below comparable US debt and 7 bps below German debt (each holding AAA debt ratings). 

To me this suggests that the CAD is becoming a safe haven currency.  This move is substantiated by double digit immigration and high levels of international capital inflows both of which demonstrate that Canada is globally the preferred place to live and invest.  This new disconnect – that is the Canadian (resource based?) currency as a safe haven, is something to be proud of for Canadians but it will and can cause problems for our exporters. 

Bank of Canada Governor Mark Carney stated last week that the world is in a multi-decade commodity boom.  The effect of this according to economist Patricia Croft and David Rosenberg is that over the next 3-5 years a $1.20 USD/CAD exchange rate could prevail. To me, the trend has become fact.  For Canadian exporters and those investing in the United States, what steps is your organization taking to ease the potential pain?