A Comparison Of Liquidity Expansion Efforts In The Eurozone And The US - Implications For The Euro-Dollar Trade
With the vast majority of analysts focusing on American monetary expansion, few if any seem to be looking at what the monetary situation is in the Eurozone. Alternatively, looking at relative strength of the dollar vs the euro, one may suggest that aggressive monetary expansion is the only factor that needs to be addressed. Some highlights of European monetary aggregates confirms just that (especially when juxtaposed with American counterparts), and present several questions: i) when will Europe catch up with the US in expanding various monetary bases, and ii) what will happen to the EUR once the ECB realizes that it needs to recreate the Bernanke Moral Hazard Doctrine and start expanding monetary circulation to the same extent as the Federal Reserve already has?
M2 and M3 are the broadest monetary aggregates tracked by central banks. While the US no longer tracks M3, the Eurozone has been kind enough to continue supplying this information. As a reminder, the ECB M3 comprises of the following: Currency in circulation, Overnight deposits, Deposits with an agreed maturity up to 2 years, Deposits redeemable at a period of notice up to 3 months, Repurchase agreements, Money market fund (MMF) shares/units, and Debt securities up to 2 years. The last three are components only of M3, not of M2, and comparably so in the US. As we have presented previously, both repo markets and money markets are among the most critical marginal components of monetary aggregates: due to the rapid fluctuation in these datasets, especially in the post-Bear Stearns period, keeping a perspective of how they are intertwined with other monetary proxies is more critical now than ever.
Below is a chart demonstrating the plunge in the ECB's M3: the year over year collapse in this most comprehensive aggregate has been unprecedented, with just a 1.7% increase over the prior year period. This is the lowest M3 expansion in the last three decades! It appears Europe's efforts to add incremental liquidity are failing completely, or have yet to be implemented. Is it thus any wonder why the dollar-euro relationship is so skewed? The message at all those G20 meetings seems to have been that only Bernanke is allowed to inflate assets, with the dollar being the sacrificial lamb, while no other central banks are allowed (or expected) to do a comparable balance sheet expansion.
This begs the question: does Europe anticipate not having budget deficits of the same magnitude as America, and if the answer is that it does, then does Brussels expect to simply raise taxation massively to compensate for budgetary drop off? As this is political suicide, it is likely only a matter of time before the ECB is forced in the same bad as the Fed, and starts monetizing like a Ben Bernanke on crystal meth. Furthermore, with certain European banks still having leverage and capitalization ratios that are soundly greater than their respective GDP's, the thesis that monetization is merely a matter of time is reinforced further, as debt inflation will have to occur elsewhere as well. Thus the only open question is: why is the ECB delaying so much? And the answer is that everyone seems to be avoiding a race to the bottom at the same time, and instead a concerted attempt is made to have sequential currency devaluation. The ECB presumably expects that fringe economies will continue to be bailed out by the IMF with fallout being mostly contained to the core of the ECB before it also is forced to put the Heidelberger druckmaschinen on turbo overdrive.
This conclusion is justified by an apples to apples comparison of European to US M2 comparison: the broadest moentary aggregate made available by the Fed. First we present a relative comparison of the European M3-M2 delta.
What is notable here is that the M3 exclusive components in the ECB seem to be taking precedence, which is expected - repos and money markets are contracting rapidly for a variety of reasons, comparable to what we have discussed as the parallel dynamic in the US. However, the overall broad pattern in movement between M2 and M3 is consistent, and is indicative of a major collapse in monetary aggregation, and an inability to flood the markets with excess liquidity.
How does ECB M2 and US M2 compare:
It is evident that after a period of time in the mid 2000s when the Eurozone was playing catch up with the US by pumping massive amounts of liquidity in a cheap funding environment, characterized by dollar-denominated asset purchases, the last year has been a dramatic reversal. While the delta has not hit the all time wide, set in 2001, the most recent reading indicates that M2 growth in the Eurozone has been virtually throttled. An observations again from the early 2000's indicates that this seems to be the ECB's MO: initial relative reduction in monetary expansion (relative to the US) and when all signs turn green, followed up with a massive liquidity expansion.
The take home message here is whether the ECB will be correct in its assumption that the current episode is comparable to the one experienced in the beginning of the decade. In other words, with monetary expansion cut off at least temporarily, will the ECB have enough time to turn on the printing presses sufficiently far down the line before the debt overhang problem in Europe becomes as staggering as the comparable one in the US. Yet with Europe not faced with a CRE cataclysm of the same magnitude as the US, it would appear Trichet has the benefit of at least some additional time. And that is the current bet driving the high euro, low dollar trade. In the meantime, if an unexpected "domino effect" event occurs in Europe, and the ECB is forced to urgently take monetary matters into its own hands by rapidly expanding the M2, look for the euro to tumble, and do so with a speed unmatched before, compliments of the dollar being the current carry funding trade, with trillions of shorts needing to be unwound on very, very short notice.