FX Market Voice: Are Concerns About Greece Resurfacing?

by: Lipper Alpha Insight

By Ron Leven

In the April Market Voice, we outlined a number of reasons why financial stress could reemerge in the EUR market heading into the summer months. In addition to the uncertainty of the 23 June UK referendum, we were concerned that Greece was showing little progress in addressing their debt overhang. And despite aggressive liquidity creation from the European Central Bank (ECB), there was little evidence of much credit generation. The ECB's adoption of quantitative ease has been successful at maintaining a steady growth rate for the relatively narrow M1 monetary base. As shown in the chart below, the broader M3 base, which is more credit sensitive, has also been expanding, largely influenced by the M1 sup-component. When M1 is filtered out, the balance of M3 which is particularly credit sensitive continues to shrink. This suggests the ECB's adoption of negative rates has had little effect on the expansion of bank credit. Indeed, the ECB recently recognized the need for more aggressive liquidity expansion, broadening its bond purchases to include corporate issuance and moving further into the realm of quantitative ease.

Figure 1: Euro-Area M3 Supply and M3 Supply Less M1

Source: Thomson Reuters Eikon

Increasing Risk in Government Bond Yields

The chart on the following page shows a broad increase in European sovereign risk in the form of higher 10-year bond yields. Greek and Portuguese bonds have risen sharply since the end of May and Portugal is nearing the highs of the year. The rise in Spanish and Italian bond yields is more modest, but they too are near highs for the year. In the meantime, German 10-year bond rates have fallen, dipping into negative territory for the first time ever. The spread between Portuguese and German bond yields is approaching its highest level since early 2014. The market is showing a clear preference for credit risk in core Europe over the periphery.

Figure 2: 10-Year Government Bond Yields

Source: Thomson Reuters Eikon

The lack of credit expansion is also apparent in the relatively poor performance of financial stock in the European periphery, particularly for Portugal. As shown below, Portuguese financial service stocks have not regained any of the ground lost to comparable German stocks during the GREXIT crises. More importantly, the rebound of EUR above USD1.10 is not fully supported by the trend in Portuguese financial stocks. In absence of a recovery of Portuguese banks stocks relative to Germany, it appears the EUR is headed lower.

Figure 3: Portuguese vs. German Financial Stock Performance and EURUSD

Source: Thomson Reuters Eikon

More Signs of EUR Stress

When the Swiss National Bank (SNB) was actively defending a floor on EURCHF, Swiss foreign exchange reserves grew to fund any required intervention. After the floor break, intervention support of EUR waned, but it did not disappear. As shown in the chart below, reserves have generally been varying at a pace of roughly flat to 2% per month. This suggests that there is still some downward pressure on EUR and there are tentative signs that this pressure is building. Denmark continues to peg its currency to the EUR. A temporary surge in Danish reserves occurred when the EURCHF floor broke, as shown in the chart below. For most of the past year, reserves have been shrinking. May, however, saw the biggest monthly gain since early last year; another sign that investors are looking for alternatives to holding EUR denominated assets.

Figure 4: Swiss and Danish FX Reserve Growth and EUR Appreciation (%M/M not annualized)

Source: Thomson Reuters Eikon

Is it Time to Go Long EURDKK Volatility?

There are parallels between CHF and DKK. Both central banks tie their currencies to EUR but do not face the same financial strains as the euro area. As shown in the chart below, when CHF volatility surged in the wake of the floor break, EURDKK volatility surged as well. The current EUR strains are apparent in recent EURCHF implied volatility; it seems only a manner of time before EURDKK volatility follows suit.

Figure 5: EURCHF and EURDKK 3-Month Implies Volatility

Source: Thomson Reuters Eikon