Back in October, there were those who were confused how it was possible that European sovereign bond yields could be exploding to their highest in a decade, even as the EURUSD keep grinding higher. We explained it, and said to prepare for much worse down the road. Sure enough, much worse came, and was promptly forestalled as both the Fed expanded its swap lines and lower the OIS swap rate, and the ECB "begrudgingly" ceded to LTRO 1+2 (that this resulted in nominal price gains was to be expected - after all humans enjoy being fooled when price levels rise when in reality just the underlying monetary base has expanded). But how did the EURUSD spike fit into all this? Simple - FX repatriation. This was explained as follows: "the sole reason for the EUR (and hence S&P and global 100% correlated equity risk) surge in the past 9 days is not driven by any latent "optimism" that Europe will fix itself, but simply due to the previously discussed wholesale asset liquidations (as none other than the FT already noted [15]), which on the margin are explicitly EUR positive due to FX repatriation, courtesy of the post-sale conversion of USDs to EURs. Which means that the ever so gullible equity market has just experienced one of the biggest headfakes in history, and has misinterpreted a pervasive European, though mostly French, scramble to procure liquidity at any cost by dumping various USD-denominated assets, as a risk on signal!" It appears we are now back into liquidation mode, and the higher Euro spread surge, the faster EURUSD will rise as more and more FX is "repatriated." In other words, as back in the fall of 2011, the faster the EURUSD rises, the worstr the true liquidity situation in Europe becomes: a critical regime change, which will naturally fool the algos who assume every spike up in EURUSD is indicative of Risk On, and send ES higher when in reality, the underlying situation is diametrically opposite.
For those who missed the article back in October 2011, here it is again [16]:
The Biggest Market Headfake Ever: Is A Wholesale French Bank Liquidity Run The Sole Reason For The Euro, And S&P, Surge?
Over the past two weeks, there is one simple thing that has been bugging skeptical macro observers: namely the paradox of i) just how ugly the European funding and liquidity situations have gotten, on the one hand, confirmed by the blow out in French bond yields (the French-Bund 10 year spread just hit an all time record yesterday [17]) as well as continuing deterioration [18]in credit spreads across core European nations, yet, on the other, ii) the euro, especially in that critical pair the EURUSD, has seen one of its most explosive rises in recent history, which as Zero Hedge pointed out yesterday, has totally decorrelated with the French-Bund spread [17], to which it had been firmly 'pegged' previously. As a result of ii), equity markets have surged due to legacy correlation arbs, which see Euro strength, and hence dollar weakness, as an empirical signal of equity "cheapness", which in turn leads all algos to treat a rise in the EURUSD as a buying signal. So how is it that even with the interbank liquidity situation in Europe frozen and getting worse, further keeping in mind that European banks are now expected to (or have already commenced - see yesterday's move [19]in PrimeX) engage in widespread asset liquidations, that broad market risk is perceived as cheap? Simple. As the following note by Deutsche Bank's Alan Ruskin explains, the sole reason for the EUR (and hence S&P and global 100% correlated equity risk) surge in the past 9 days is not driven by any latent "optimism" that Europe will fix itself, but simply due to the previously discussed wholesale asset liquidations (as none other than the FT already noted [15]), which on the margin are explicitly EUR positive due to FX repatriation, courtesy of the post-sale conversion of USDs to EURs. Which means that the ever so gullible equity market has just experienced one of the biggest headfakes in history, and has misinterpreted a pervasive European, though mostly French, scramble to procure liquidity at any cost by dumping various USD-denominated assets, as a risk on signal!
In other words, an internal bank run has somehow been interpreted to be stock positive... And there is your explanation for not only the paradoxical surge in the EURUSD and S&P, but why the correlation between the EURUSD and the Bund-France spread [17]has completely broken down. Expect all of this to promptly, and very violently, correct once the market understands what an idiot it has been in the past two weeks.
From Deutsche Bank:
In the last few days there has been talk that European bank repatriation of capital may be behind EUR strength. Setting aside the timing of asset sales, and the reduced universe of potential bidders for these assets, it is worth considering what happens when a European bank sells USD assets. European banks in aggregate are regarded as having a still sizable shortfall of USD liabilities. The BIS has done some of the most comprehensive work on the USD shortage (see in particularly working paper: www.bis.org/publ/work291.pdf [20] ). The most recent data for the end of 2010 (see the latest BIS annual report page 104), suggested the funding shortage had declined by at least half compared to before the 2008 crisis. More recently. the dependence on cross currency funding has gone up again, with the decline in US money funding. (DB’s Bill Prophet showed EUR region CDs of 7 of the 10 largest US money funds fell by over $70bn from May through September). Given this collapse, it is likely that European banks that do successfully sell USD assets, will try maintain the corresponding USD liability to mitigate against USD term funding that may not be rolled in the future. If a European bank sells a USD asset, it probably reduces the European Bank shortage of USDs by the sales amount. A smaller ‘USD shortage’, at the margin reduces the risk of a short USD squeeze of the sort seen in 2008, and to that extent is a minor USD negative, and EUR positive. It also fits with the EUR cross currency basis swaps coming in slightly of late, although this almost certainly has more to do with global risk appetite. This marginal USD negative, EUR positive impact, should not however be confused with a foreign exchange transaction whereby USD’s are converted into EUR.
Even Deutsche Bank is scratching its head to explain the dichotomy between the funding market and general risk. They do, however, provide the only real explanation, as opposed to the widely trumpeted by market cheerleaders ridiculous explanation that this is merely the latest "hope" rally. Ridiculous, because if that was the case, one would see a thawing of interbank liquidity and defaults spreads. As Zero Hedge readers know, 100% the opposite has happened.
Note also that the EUR is going in the opposite direction to much purer gauges of EUR tensions in the bond market. The collapse in OATS today is a major story. This is not least because France is experiencing the negative side of its (still) AAA status and being a member of the core - the fiscal transfers are going toward the periphery and away from the core in terms of ability to tap the EFSF for bank recaps, and possibly bond insurance/guarantees. In the past, we have noted that the periphery flows fleeing toward the core has tended to leave the EUR trading like a closed system to the outside world, which is one explanation for surprising EUR resilience to periphery travails. The latest French balance of payments data (http://www.banque-france.fr/gb/statistiques/economie/economie-balance/ec... [21] ) again shows large French portfolio inflows that are very surprising, although the large errors and omissions do suggest the data is incomplete. (In the future, Target 2 balances will be another vehicle to use to check the degree to which inflows are being concentrated in Germany solely). In any event, instability in the French bond market has the capacity to significantly reduce points of refuge for risk averse funds at the EUR’s (shrinking) core, and adds to DB FX team’s doubt about the sustainability of the EUR’s rally...
And so on.
Naturally, the Eurocrats will be delighted to associate the run up in risk assets and the European currency as a confirmation that the market is interpreting further lies, innuendo, and confusion as a risk on indicator, and is encouraging their behavior, when nothing is further from the truth. However, the biggest beneficiary of the recent move is none other than the insolvent French banking system, whose very own liquidity run has caused asset values to soar, on an epic misinterpretation of underlying market signals, and thus sell even more into market strength, when in fact the market should be selling alongside France...
As for unwind catalysts for this most insidious market move, we are confident that the inability of the G20 to come up with any resolution over the weekend in Paris, nor the Eurozone Summit in one week to actually present any relevant details vis-a-vis the continent's bailout, or the EFSF's expansion into some multi-trillion Bailoutstein monster, will not be met too happily by a market which has just realized it has been thoroughly fooled by the cash-crunched French banking system.