Where are all the euros going?
By James Mackintosh and Alice Ross
Strange days have tracked us down/ They’re going to destroy/ Our casual joys
American rocker Jim Morrison of The Doors has the closest possible link to the eurozone: he’s buried in Paris. Coincidentally, his angst-ridden lyrics sum up the peculiarities of the region’s markets as investors worry that they are approaching the end of days, at least for the single currency.
The weirdness is not just that the euro has risen this week, although given the challenges it faces that does seem odd to many. Rather, there is a problematic question of where all the euros have been going.
While the currency has risen, money was coming out of German bonds, previously the favoured security blanket of risk-averse investors; out of equities, the obvious way to bet on recovery; and out of peripheral bonds, with Spanish 10-year yields hitting 7 per cent on Thursday, borrowing costs widely seen as unsustainable.
“It has been a curious week,” says Simon Derrick, chief currency strategist at Bank of New York Mellon.
Just as odd, on Friday everything went into reverse. German bonds held appeal again, with yields dropping, the euro fell slightly and yet equities rallied strongly.
Normally the trifecta of bonds, equities and currencies follow simple rules. If the euro is stronger, more money is flowing in and either bonds or equities, or potentially both, are rising. If it is flat, euros can move between bonds and equities, so one or other of them could be up, and the other down. If the currency is weaker, then money is flowing out, and investors are selling either bonds or equities (or, less often, both).
The explanations for this week’s weird moves revolve around the Swiss franc, bets on the creation of a new Deutschmark and caution ahead of Sunday’s Greek election, which many fear could pave the way for the country’s exit from the eurozone. “Flows were going into the Swiss franc,” Erwan Mahe, strategist at Paris broker HPC, says. “But you can’t see it in the currency move, only in the bond market.”
The Swiss National Bank has set a floor of SFr1.20 to the euro. As worried investors (and Swiss companies) convert euros into the haven of Swiss francs, the central bank mops up the inflows and buys euros. This week investors were picking up rock-solid Swiss bonds, pushing their prices up and yields down – with new record lows set for the five-year bond yield on Tuesday, Wednesday and Thursday, even as German bond yields rose.
Meanwhile, the Swiss central bank has to do something with its newly acquired euros. It is widely believed to be using Dutch bank Rabobank to trade, and is thought to be trying to diversify away from Germany, while keeping safer euro assets.
Money parked in cash at Rabobank would probably end up in Dutch short-term paper. Sure enough, Dutch two-year bond yields actually fell, even as other core eurozone bond yields were rising. Diversification of Switzerland’s euro investments might also explain why the extra yield on offer from French bonds compared to Germany compressed during the week.
The scale of SNB purchases is becoming a big driver of bond markets, as well as currencies. It spent more than SFr60bn (€50bn) last month alone to weaken the franc, and Geoffrey Kendrick, currency analyst at Nomura, estimates it has used another SFr12bn already this month.
Still, it is impossible to be sure what has prompted this week’s action. “There are these anomalous price moves but in a week which runs up to what could be a monumental event it’s very difficult to say what is driving them,” says David Bloom, head of currency strategy at HSBC.
Many investors have been cutting back on risk ahead of the Greek election, covering short positions in the euro. That reduces market liquidity, meaning big moves are possible on relatively small trades. Some of the euros could have gone into paying down debt – with European banks themselves also deleveraging, after repatriating euros, according to Mansoor Mohi-uddin, head of currency strategy at UBS.
The psychology of investors is hard to pin down, but proved vitally important. Many have finally woken up to the danger of German bonds, after scarily low yields on the 10-year Bund, which reached 1.13 per cent at the start of the month. This week yields leapt above 1.5 per cent briefly, closing at 1.44 per cent, in part because of the fear that Germany might end up paying for more eurozone rescues.
Buyers of German bonds had not just been hoping to find safety. Many were also betting on being paid back in Deutschmarks if the euro broke up, and so making big profits as a new Germany currency would almost certainly soar.
But with yields at record lows, that bet began to seem expensive – and investors started discussing the risks. Even if Germany were to leave the eurozone, it has no obligation to redenominate its euro bonds, and would cut its debt costs sharply by not doing so.
“They might pay domestic [creditors] in Deutschmarks, but I don’t see why they would pay internationals,” says Lee Robinson, founder of hedge fund Altana Wealth.
Furthermore, a similar bet could be made with better yields by buying Dutch, French or Austrian bonds, hoping that they would join a new “northern euro”.
All these factors are likely to have played a part, with low liquidity exacerbating the situation. When trading returns after Sunday’s election we will see whether these patterns were a one-off or signs of a new paradigm. |
