Based on a swap-spread-based model, EURUSD should trade around 1.30, but based on GDP-weighted sovereign credit risk EURUSD should trade around 1.00; so who is right and what are the factors that supporting the Euro at higher levels than many would assume (given the rising probability of a Euro-zone #fail and the 0.82 lows from 2000). UBS addresses four key reasons for the apparent paradox based on the difference between ECB and Fed 'monetization', the EZ's balanced current account (independent of foreign capital flows), and the high-oil-price induced petro-dollar circulation diversifying into Euros (or out of USD). The final and most telling of factors though is bank deleveraging as European financial entities, who remain under pressure to shrink their balance sheets and re-build capital, have been selling foreign assets. They remain EUR dismalists with a year-end target of 1.15 but expect the slide to these levels to be cushioned (absent an imminent break-up) by banks' 'shrinkage'.
Based on a pure swap-spread model, it appears EURUSD is starting to price in liquiidty risk once again (as it did last year - green ovals)...
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But the pressure remains on EURUSD via the massive rise in credit risk across the Union's members (with parity seemingly attractive)...
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and so from UBS - EURO - Who's Buying?
Financial markets are starting to price in the risks that the Eurozone may split apart following this month's inconclusive elections in Greece. But the euro, while trading back to this year's lows against the dollar at 1.27-1.28, remains far above its lifetime lows of 0.82 recorded in 2000.
What explains this paradox?
First, the European Central Bank so far has not engaged in outright quantitative easing during the financial crisis. Moreover, while the Federal Reserve, the Bank of Japan and the Bank of England all have cut interest rates to between zero and 0.5%, the ECB's benchmark interest rate remains at 1.0%. In contrast, investors are concerned the Federal Reserve will engage in a third round of quantitative easing. Similarly, the Bank of Japan and the Bank of England have also been printing money and buying government bonds.
Second, the Eurozone as a whole runs a balanced current account. Thus it is not dependent on foreign capital inflows to support the value of the euro.
Third, high oil prices have increased the petro-dollars accumulated by central banks and sovereign wealth funds in the Middle East, North Africa, Commonwealth of Independent States and Norway. These official investors diversify a portion of their new foreign reserves into Eurozone markets.
And, last, Eurozone banks under pressure to shrink their balance sheets and rebuild capital have been selling foreign assets.
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As Chart 1 shows the ratio of loans-to-deposits peaked in the Eurozone close to 125% in 2007 when the credit crunch began. Since then the ratio has declined to 115% but largely because of an increase in deposits. As Eurozone banks further reduce the size of their balance sheets, they are likely to cut loans now including those from abroad. That leads to repatriation flows supporting the euro.
How long can such deleveraging go on?
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Chart 2 shows how the ratio of loans-to-deposit has fallen from its peak in Japan in 1992, the US in 2008 and the UK in 2007. For the last two decades Japanese banks have steadily reduced their loans-to-deposits ratio from 130% in the early 1990s to below 80% now.
American and British banks have also been deleveraging sharply over the last few years. But Eurozone banks have been much slower, suggesting they will spend many more years slimming down their balance sheets now. That should lead to more repatriation flows to the benefit of the euro.
Thus while the euro is set to keep sliding owing to the debt crisis in the Eurozone - our end year target is 1.15 against the dollar - in the absence of a break up of the single currency area, the euro's decline should be cushioned by the Eurozone's banks.