The euro will recapture some of the lost ground

Outlook

The calendar is light today, with nothing of interest in the US except economists revising their GDP and first-hike forecasts. Tonight we get Chinese PPI and CPI, with trade and reserves the next day, but worries seem have died down about a hard landing (and these numbers are among the least trust-worthy, any-way). Tomorrow we get the June 5 FOMC minutes, which might be fun.

In order for the dollar to benefit in a more lasting way from the payrolls bombshell, we think two things need to happen: first, the yield differential has to rise further to favor the dollar. That means 2.85% to 3%, and preferably more. So far, according to Bloomberg, “The extra yield that 10-year Treasuries offer over their Group-of-Seven counterparts expanded one basis point to 74 basis points, the most since April 2010.” But 74 bp is not enough, as we have seen. It needs to be an unmistakable and stable premium of more than that, possible as much as 1.5-2.5%, to underpin the dollar. So if the Bund is at 1.25%, the US 10-year needs to be at 3.75%, or another 110 bp from this morning’s quote at 7 am. This is not going to happen overnight and may not happen at all, especially if the Fed jawbones it lower (for the sake of the mortgage mar-ket, for example). The Fed doesn’t want another taper tantrum. Besides, a swift rise of 100 bp would be unhappy news for the stock market, bubble or not. So this dollar-support may be coming, but not today or tomorrow.

The other condition would be the euro falling for its own reasons, and market analysts are already saying that Draghi’s announcement last week of refinements to the plan to boost private credit does not hit the mark. Bloomberg has a scath-ing story pointing out that the €1 trillion in new bank lending trumpeted by Draghi doesn’t actually require banks to in-crease private credit—the purported purpose: “… to keep the initial batch of funding for the full term, banks aren’t re-quired to expand their loan books. They are only obliged to boost credit if they wish to borrow more cash starting next year, when the ECB will provide as much as 3 euros for every 1 euro of net new lending.”

This is how it works: the long-term refi operation will give banks an extra €400 billion this year with no strings attached until 2016. What do banks normally do, especially when they are being audited for credit quality? They park the money at the central bank, exactly as they did in the first LTRO. Draghi said the new plan is “quite attractive,” but analysts don’t see it, at least not until the reviews are completed in the fall and the ECB takes over the regulatory function in November. Besides, do we have evidence of demand for credit? We do have evidence that companies in the southern tier are paying more than in the north, but that’s not the same thing as de-mand.

The second leg of the activity boost is the ECB buying asset-backed securities, which are few and far between with issu-ance falling in recent years, as reported last week. But in the end, this might be the escape hatch. That’s what Werner Sinn, head of IFO, thinks, if we draw some inferences from his comments last week. Sinn is one of the top macro ana-lysts in the world today and we should always heed his words. He says the southern tier needs debt relief and right away. Moreover, creditors should bite the bullet and take the losses. In an interview with Bloomberg, Sinn said “The Asian financial crisis that started in 1997 was resolved with debt forgiveness rather than by drawing on taxpayers’ money, providing a model that European policy makers should use. Households and companies are over-indebted, banks are over-indebted, states are over-indebted and national central banks are over-indebted [in the eurozone]. It’s not nice for the creditor to recognize that he won’t get his money back, but the sooner he faces the truth, the better.”

For example, Bloomberg inserts, “Italy’s debt rose to 2.15 trillion euros ($2.9 trillion) in April, approaching outstanding borrowing of top credit-rated Germany at the end of 2013. Greece’s debt, now mainly in the hands of public creditors, is 175 percent of gross domestic product while more than a quarter of the workforce is jobless.”

Sinn is calling for a debt conference to address debt burdens at “almost unbearable” levels. “Removing toxic loans from banks’ balance sheets would help make lenders fit for the stress test the ECB is running until October, said Sinn… Yet the ECB doesn’t have a mandate to channel investment to parts of the economy where they wouldn’t otherwise flow, he said. ‘The issue of possible deflation dangers is being used to prepare a policy of quantitative easing by the ECB that serves not only to combat deflation, but also to save the banks. But that raises the question of whether the bank is even allowed to do this, or whether it should.’” In other words, QE in sovereign paper doesn’t solve the overindebtedness is-sue. But logically, a ramped up program of ABS would start pricing some of the private debt properly. Okay, this to pro-mote interference in a free market by a central bank, but qualitatively, re-pricing private debt may be better than backing all sovereign debt willy-nilly. At least it’s the right question.

For the immediate future—today—we see the euro recapturing some of the lost ground to probably the midpoint of the Thursday breakout bar, or 1.3626. But if worries about Draghi’s dovishness and the insufficient institutional proposals continue to grow, the euro should fall back again. We see a break of 1.3500 as a long, drawn-out, rangey misery, though.