Parsing Last Thursday's Euro/Swiss Franc Drama

Includes: EUO, FAS, FAZ, FXE, FXF, SPY
by: Bo Peng

Last Thursday's market brought back sweet old memories of late 08 and early 09. In other words, massive dislocation. Nothing made sense. U.S. equities dropped, gold dropped, Libor/Euribor surged although the ECB liquidity roll was supposed to be much smaller (better) than expected, EUR and GBP surged in record speed/amounts like they became the new reserve currency all of a sudden, CHF tanked, USD and JPY were reduced to dependent variables as if irrelevant. And, while all the excitement was going on, credit spreads were in their separate leisurely universe

It was immediately clear to me that what was happening was not the usual risk-on/off trade. But it took me a few minutes to get past the shock-and-awe and put the pieces together: It was a massive liquidation. Somebody needed cash, or cash Euro specifically, and needed it fast.

There had been a massive flow from EUR to CHF since May, with Swiss National Bank being about the only EUR buyer. The reason why the ECB liquidity roll was low was not that European banks didn't need liquidity. It was because the ECB rate of 1% is too high compared to money market rates now, as opposed to when it was offered a year ago. Apparently many banks took up the arbitrage offer, borrowed the money at 1% and bought higher-yield but safe securities, e.g., PIIGS sovereign. Now the safe securities have either matured or dumped to ECB, they have no need for 1% funding, especially for a shorter term of 3-months. FT Alphaville has extensive and excellent coverage on this topic.

But, as expected, the money market rates went up exactly because of the low roll amount, European banks found it necessary to unwind some positions and get cash. Since there had been a massive short position on EUR and long on CHF, the unwind by European banks probably set off a small chain reaction. Now somebody else, presumably hedgies and probably including some owned by U.S. banks, either got squeezed (short EUR, GBP or long CHF) or needed cash (long gold, equities), or both.

There were plenty of other important news pre-open that day, especially China PMI and initial jobless claims. Both were important factors for U.S. equities, but I doubt they were strong factors in the record-setting drama in EUR/CHF/gold land.

What does it mean going forward?

  • USD is still the only reserve currency (whew). EUR and GBP are still weak long term, especially if austerity measures are implemented in UK/Germany/France. CHF is still strong long term, although SNB may have come out of its coma and intervened again.

  • Gold is still strong. The record commercial short on gold is probably a short-term bullish factor, especially after the recent down move.

  • European banks are squeezed by higher funding costs; otherwise as shaky as before.

In short, for all the drama, nothing changed on the fundamental aspect. CDS market was right.

But more importantly, what could change the status quo? Plenty.

  • Double dipping and deflation risk seem to have gained substantial traction in mainstream thinking. QE 2.0 could be coming, which promises total dislocation in global markets. As Bernanke laid out back in 2002, early in his current tenure, the next steps include buying long dated treasuries to flattern the curve, making direct private loans (yes, Fed can do that), and/or lowering USD exchange rates (hello Japan, China, and Switzerland, let's see who's the tough guy and get to the bottom first). And, while we're on the lunatic express, why not negative interest rates? Notice that our genius economists spell out these ideas with perfect straight face. They don't see any problems with it. Trivia such as fairness at the individual level and social order are totally below them-- it's not their job.

  • When will QE 2.0 come? Majority thinking says it won't come before the November election. But what if things turn really grim before then?

  • Now that the FinReg bill is temporarily stalled in Senate, there's more uncertainty in many directions.

  • Publication of European bank stress test results could be written off, as currently expected, since it doesn't include sovereign risk, or reveal very interesting insights on individual banks.

  • Implementation of austerity measures in Europe is still highly uncertain.

  • Economic outlook in China remains highly uncertain.

  • Q2 earnings are coming up. I think there'll be lot of misses because projections have been revised up after strong Q1 results and things have turned decidedly sour since. We'll find out soon enough.

  • The 1040 support in SPX has been talked about by so many for so long, penetration thereof felt like an utter anti-climax. But what if ECRI lead indicator drops 10% (-7.7% latest)? SPX drops 20% (now -16%)?

As I said, crises will keep happening until we stop wasting them.

Disclosure: Long EUO, Long puts on FAS