While the good times are about to end for the Japanese Bond Market (as shown in yesterday in Counting Down To Japan's D-Day In Two Charts [18]), the reality is that anyone who bet on an surge in Japanese bond yields in the past few years has been carted out feet first. Which is also why shorting the Japanese bond market has been widely known as the "Widowmaker" trade in the investing community. However, according to Charles Gave, another "Widowmaker" has emerged in the past year: "It looks like the euro is competing to grab title for itself. Many traders have been shorting the currency, with poor results so far."
Paradoxically, ever since Mario Draghi's "whatever it takes" speech in July of 2012 when redenomination risk (i.e., the collapse of the Eurozone and the end of the Euro) was the biggest threat for the Eurozone, the Euro has risen by a staggering 1700 pips against the dollar. It has gotten so bad that not only are European corporate profits getting crushed [19]on the back of the strong currency, but despite the ECB's repeated attempts to talk down the Euro, they consistently achieve the opposite.
So what explains the persistent strength of the Euro? Here are some perspectives by Charles Gave of Evergreen Gavekal.
How to explain the strange and irrepressible strength of the euro? Let’s start with a simple idea: if the euro is going up, it is probably because we have more buyers than sellers. Armed with this profound knowledge, we can start to try to identify who these buyers are. In my opinion, the largest buyers fall into two categories:
1. German companies. Contrary to popular opinion, Germany is not struggling against the burden of an overvalued currency. In fact, as the chart below shows, for Germany the euro is basically as undervalued as the dollar. For France, however, the euro is 11% overvalued against the dollar; and for Italy and Spain, the single currency is 11% overvalued. Ergo, Germany is undervalued against these countries by the same amounts. And as a result of Germany’s global currency competitiveness, it has moved from a current account deficit (ex-Europe) in 2005, to an annual surplus with the world (ex Europe) which is now around €125bn.
Now, most of the German exports outside of Europe must be billed in US dollars—let’s estimate about €100bn annually worth. Since the net costs incurred by Germany in producing these exports have to be paid in euros, then it means that German companies must buy roughly that same amount of euros per year (unless German FDI was also this high, but is not). If the deutschmark still existed as an independent currency, this would push the unit higher. Instead, it pushes the euro higher, which leads to the French, Italian or Spanish companies becoming even less competitive against their German competitors, which leaves the markets wide open for the said German companies. Needles to say, the Germans are willing to fight up to the last French or Italian soldier.
[20]
2. Japanese retail investors. As we all know, France has a major budget deficit and close to 70% of its government debt is owned by foreigners. In the last 12 months, Mrs Watanabe has in effect financed the €75bn French budget deficit. As Japanese investors pile into euro-denominated debt (with gross purchases of nearly €400bn year to date!), they are obviously putting upward pressure on the euro, and downward pressure on the yen.
Of course, Japanese are not the only foreigners buying French debt (so are the Middle Easterners, Russians, etc). But if we add up just these two categories alone—an approximation of euro purchases by German corporates and Japanese financing of the French deficit—we get €175bn in the past year. No wonder the euro has been going up.
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What could stop this relentless drive? Two things: i) the German current account surplus ex-euroland starts to fall—this should start to happen given the restored competitiveness of Japan (the German and Japanese product mix are 90% similar); or ii) foreigners decide they have enough of French debt, or even worse, that the time has come to take profits.
The funny thing is that in both cases one discovers that Japan, and not the US, will be prominent on the other side of these transactions. The time to short the euro will eventually come, but when it does investors will have to short it against the yen, and not against the dollar. Given the monetary policy in Japan right now, this time is probably not imminent. In the meantime, instead of shorting the euro, one could short the French, Italian or Spanish industrial companies, or perhaps the German financials
Well, there's all that. A far simpler reason is that capital flows away from where central banks are wantonly devaluing their currency, in this case the US and Japan both monetizing 70% of gross Treasury issuance every month. Furthermore, with the ECB still largely unable to enact outright monetization (not only over Germany's stern refusal but due to the legal structure of the Eurozone, where the primary beneficiaries of such monetization would ironically be German Bunds), and with excess liquidity materially declining every week with LTRO repayments by northern European banks (today's €22.7 billion LTRO repayment for example was the largest since February and pushed the ECB's excess liquidity to the lowest level since December 2011), it is no surprise why the latest New Normal carry trade involves either shorting the USD or JPY and offseting these with a long EUR leg.
Whatever the reason, the trade will continue making widows until something radically changes in the global central bank arrangement in which the Fed and BOJ are injecting copious amounts of liquidity, while credit creation in Europe continues to decline at a record pace.