If there is one cross asset correlation that defined 2011 (and the greater part of 2010), it was that of the Euro-Dollar (EURUSD) currency pair and the S&P 500, which have correlated with near unison nearly all of the time. And yet, the stability of this correlation may be getting unglued, because as Goldman insinuated in its market roundup note from yesterday, it is "reasonable to think that the ... reflexive relationship between EURUSD and SPX...will take some time to break, but this correlation should start to fray." Why? Because, "like the FED before them, the ECB is aggressively expanding their balance sheet." Which brings us to the point of this article: much to the dismay of the armies of disgruntled bankers and investors demanding that the ECB print right now, the ECB has in fact been printing, as shown the other day. Only it has not done so in the conventional sense where it assumes an "asset" on its balance sheet while expanding a monetary liability, but indirectly through shadow conduits, such as repo and other liquidity backstops, also as shown yesterday, where no new currency actually enters the system, yet whereby the balance sheet expands just as efficiently (and in doing so, dilutes the underlying currency). It is well known that it has been our contention that in this centrally planned world the only thing that matters is the global provisioning of liquidity by the monetary authority, as the ultimate marginal determinant of Risk On behavior (and inversely Risk Off), is how much ZIRPy cash do speculators (and more importantly Prime Brokers) have at their possession (for outright and (re)hypothecated purchasing purposes). So here we would like to make a distinction: it is not so much how much cash one global monetary central planner will provide to markets, but how much the various standalone central banks will inject, in whole or in part. We contend that for 2012 the key qualifier will be "in part" with the ECB and the Fed printing (either outright or via repo) in staggered regimes, and thus the primary determinant of "risk", the EURUSD, will be the relative ratio of the two balance sheets. This can be seen on the charts below, the first of which shows just how dramatic the ECB expansion has been in the past 6 months, and the second showing the correlation between the EURUSD and the ratio of the Fed to the ECB.
First, the balance sheet of the ECB vs the Fed:
And second, the correlation of EURUSD vs the relative central bank sizes: i.e "The correlation of 2012"
And where the EURUSD goes, broad risk will follow as all it indicates is a willingness of the respective monetary authority to increase liquidity. It also explains why the EURUSD is likely to trade in the 1.20-1.50 corridor for a long time, as any time the EUR currency plunges, the US economy experiences a dramatic slow down, and inversely, whenever the EURUSD approaches 1.50, Europe, and specifically Germany, sees a substantial slow down in economic output. As such, this range will specify the probable willingness of either central bank to engage in aggressive monetary easing. It is no surprise that since the ECB started "printing" in all but name in July, the EUR has seen a gradual and consistent decline.
There is another corollary: while gold has been stagnant and dropping since peaking in September on disappointment that the Fed did not proceed with outright unsterilized printing and instead engaged in offsetting LSAP-LSAS QE3 under the guise of "Operation Twist 2", gold has completely failed to notice that while the Fed has been net silent, another bank has injected a whopping €500 billion in the past 6 months, or more than the Fed did in all of QE2! Ironically, the broader "risk on" crew has not missed this, and while gold continues to be stuck in the old paradigm, it refuses to comprehend that explicit guarantees of trillions in debt (such as the LTRO repo operations), is an equivalent operation to printing money.
We fully expect the correlation arbs, which usually need someone to point out the glaringly obvious to them before they encode given relationships and correlation pairs into buy and sell signals, will very soon comprehend why the one most underpriced asset at this point, by orders of magnitude, is gold. For the simple reason that currency debasement has been going on feverishly, if behind the scenes, for the past 6 months, and gold is nothing more, or less, than a hedge against monetary dilution. By anyone. That most certainly includes the ECB as well.
We, also, for one, hope to be fully prepared for the instant when the "Eureka" moment strikes.
And here, for the benefit of said slowish arbs, to explain just why liquidity provisioning is the same as bond buying, is SocGen with an expanded narrative on how Draghi took away the bazook and replaced it with a thousand just as effective slighshots.
There continues to be an expectation that the moves to a more disciplined fiscal union will clear the way for a significant increase in the scale of the ECB’s support for the bond market. However, at December’s press conference, ECB President Mario Draghi, emphasised that the Lisbon Treaty forbids the monetary financing of sovereign debt. We also believe that the ECB wants to avoid the moral hazard implicit in large scale bond purchases since this would potentially reduce the pressure on national governments to undertake the necessary reforms. Jens Weidmann, the Bundesbank Chairman for example, has repeatedly argued that Italy “can live with interest rates over 7% for years.” This is a reference to the yield curve simulations included in the latest BIS quarterly review for example, which demonstrate that even if the yields reached on 9 November were sustained, the relatively long maturity of Italy’s debt stock (around 7 years) means that it would take years for the debt service costs to snowball significantly. This is a clear indication, that in the Bundesbank’s view at least, the ECB will not be intervening to set a ceiling for bond yields.
In our view therefore, any increase in ECB bond buying is likely to come in the form of greater longevity rather than an increase in size, although the ECB may not acknowledge this explicitly. Even so, we envisage the ECB’s SMP continuing at roughly its current volume throughout 2012 and potentially into 2013. This probably implies a further €200-250bn of bond purchases over the next twelve months which would mean the ECB is effectively absorbing the new gross supply from Spain and Italy. This implies roughly a doubling of the SMP to the €500bn mark over the next 12 months. Overall, when one takes into account all of the ECB’s policy initiatives then amounts involved are indeed adding up. Taken together with the relaxation of reserve ratios, which we think is worth about €100bn, the roughly €300bn of excess liquidity the ECB and the ECB’s covered bond purchase programme (currently just over €60bn but planed to increase by another €40bn), then the ECB’s interventions are actually very sizeable. The extension of the ECB’s money market operations to 3 years may also prove to be significant since this will provide banks with additional funds that are in turn likely to be invested in sovereign bonds up to a similar duration – something that the French Central Bank Governor, Christian Noyer has described as “our bazooka”.