Stop us when this sounds familiar: 'While we expect central banks globally to continue to provide liquidity, it is the ECB’s position that has changed the most dramatically. The relative expansion of the ECB’s balance sheet is EUR bearish in our view....the liquidity being generated by the ECB is to a large extent absorbed by the bank refinancing process, hence the large deposits at the ECB. Although there is clear evidence that some of the funds have been used in the peripheral bonds markets, helping to stabilise sovereign yield spreads, lending into the real economy remains constrained. We believe that the relative performance of money multipliers will be a significant driving force for currency markets in the coming year. We see the ECB liquidity as a negative for the EUR" At this point the preceding should remind our readers, almost verbatim, of this Zero Hedge post from January 31 [10], "Reverting back to our trusty key correlation of 2012, namely the comparison of the Fed and ECB balance sheet, it would mean that absent a proportional Fed response, the fair value of the EURUSD would collapse to a shocking 1.12 as the ECB's balance sheet following this LTRO would grow from €2.7 trillion to €3.7 trillion." And the reason why the latter extract should remind readers of the former is because it is the basis for the just released conclusion by Morgan Stanley cutting its EURUSD price target from 1.20 to 1.15.
MS' forecast chart on the pair:
[11]
As for the basis of our assessment, we used the following chart showing the relative and projected sizes of the ECB and Fed balance sheets as the basis of EURUSD correlations:
[12]
And here is the Morgan Stanley comp:
Some more on the MS thesis:
Expectations had been running high for progress to be made at the EU Summit, and while 25 EU members signed up to the fiscal compact, many elements were watered down, especially with regards the regulation and enforcement of the agreement. Indeed, implementation of the fiscal compact is not expected until 2013 and will still require ratification at a national level. Implementation risks remain high, in our opinion. The ESM was also endorsed, but again many details still need to be finalised. While the EU Summit has been seen as a success on many levels and may well be viewed as going some way towards starting to address structural problems in the Eurozone, the immediate problems are far from solved. As a result, any EUR relief gains are expected to remain limited in our view. Indeed, some EU officials clearly do not believe that the agreement goes far enough. The EU’s Junker has commented that the measures are insufficient and that further steps will have to be taken at the next Summit in March, highlighting the lack of centralised economic authority. We maintain our bearish EUR view, and have in fact lowered our EURUSD forecast for 2012 to 1.15, from 1.20 previously.
However, while the January EU Summit agreement may fall short of original expectations, the importance of the steps currently being made should not be under-estimated, in our view. The progress being made on the fiscal front could well provide the pre-conditions for further policy measures, which we believe will be effective in helping to address many of the more immediate issues in the Eurozone. But once again we would advise caution regarding the currency interpretation.
While perceived progress will likely provide support to peripheral bond markets and Europe asset markets, we still believe it will be a mistake to translate such developments into a bullish EUR view.
It is worth noting that peripheral bond spreads have stabilised and CDS spreads have also adjusted lower in many cases, resulting in a significant shift higher in our measure of risk adjusted yields, which has historically been associated with a rebound in EURUD. The fact that the EUR has not been able to take advantage of the more supportive environment, as highlighted by the rise in risk adjusted yields, is further evidence supporting our view that the fundamental picture for the EUR remains weak.
Needless to say, a collapse in the EURUSD will evoke an inevitable and violent response by the Fed, something we noted before, and something which MS also, wink wink, has realized:
...analyzing the impacts of QE1 and QE2 we made two observations. First, the market impact of QE2 was significantly smaller than that of QE1 and second, QE2 developed a front loaded impact. We think markets have started pricing in QE3, suggesting upside potential following the formal announcement of QE 3 will be limited. Once QE3 begins, it may be time to implement currency trades that benefit from risk aversion.
It is our view, that once the EUR implodes, the Fed will have no choice but to intervene yet again, thereby sending the USD plunging and the EURUSD back to 1.50 or so, but everything in its course. Markets which have a tendency to frontrun everything, and which have now priced in the global central bank put in perpetuity may want to remember tha absent a 20% correction in either stock market monetization just ain't going to happen. Or rather, it will one way or another, only it will be far more violent.
Finally, now that MS openly disagrees with Goldman once again, it bears reminding that the last time Morgan Stanley [13]was on the other side of the trade from Tom Stolper, MS was proven right [14]in about 48 hours. It will be proven right one more time.