Thursday, May 10, 2012

BNY Mellon's Currency Strategist on the Euro

The CFA Society of Minnesota hosted Samarjit Shankar and Simon Derrick of BNY Mellon. Shankar's presentation covered their iFlows product for traders which tracks $33 trillion in daily institutional trading volumes, which he said is about 15-27% of overall volume.  These represent real transactions and real positions submitted by their clients, which are aggregated, parsed and returned in reports before the opening bell the following day.  It's about as close to real time flows as is feasible.

Simon Derrick is the head of the Currency Strategy team at BNY Mellon.  It was an interesting presentation, very much in line with what we've been saying since the beginning of the Euro crisis, but Derrick's presentation incorporates current iFlow data analysis and forecasts. 

Non-European investors have not pulled away from the euro, which is still key to their diversification away from the dollar.  Rather they have reallocated their purchases away from the periphery--Spain, Portugal and Poland--towards the core countries.  Current instruments of safety are bunds, U.S. Treasuries, and Swiss bonds.  The Australian dollar, charts showed, is heavily leveraged to the Chinese currency. 

Derrick noted the same design flaws in the currency union that we have noted.  His overall characterization of the euro, abstracting from any allegiance to the British position, is that it has been "a disaster."  That got some heads raised from picking at their salads.

In his view, a euro built on Germany, the Benelux countries, and Norway could have been a strong, viable currency even without fiscal unification.  Notice the omission of France from his list.  The admission of Italy, nominally the third largest European economy, was the beginning of cracks in the system.  After this admission, he says, it was politically impossible not to open up the doors of the euro to all comers.

China's reserve currency stockpile has been and continues to be a major factor in the Eurozone and in the valuation of the euro: a distinction which Derrick feels is key.  In 2005, BNY data shows that China's official reserves were 75% in U.S. dollars, whereas the level fell to 57% as of the end of last summer.  The diversification between these two periods was primarily to the euro, which kept the official euro exchange rate strong.

In fact, he says, it has been changes in Chinese reserve growth that have statistically best explained runups or flattening in the euro exchange rate.  This diversification and its impact on the euro rate are quite unrelated to current developments in the Eurozone circus of meetings, and conferences and resolutions.  I thought this was a very helpful insight, as it has been difficult for me to understand why the euro rate seems to hang at relatively high levels. 

Their forecast for the back half of 2012 is not fun.  Weakening oil prices, which we've always felt were not driven by fundamentals anyway. Slowing Chinese growth, which means zero growth in Chinese official reserves.  This means that the major pillar of support for the euro exchange rate will start eroding towards the end of the year.

European populations are totally out of sync with their elected leadership who talk about austerity.  Thus, as we have long said, it is political suicide for governments to continue to support austerity imposed by outside nations in the Eurozone. Derrick saw a scenario where "weasal words" would be used to walk away from the austerity concepts.  Classic diplomacy. 

An important announcement had been made by the China Investment Corporation that it would not add any further to its purchases of European sovereign debt.  Since the CIC had already been moving away from peripheral debt, this isn't good news for the core countries.  Derrick foresees a "quantitative easing" for Europe which will ultimately serve to put the euro in further peril.  He didn't elaborate on what this meant, but he didn't seem to be talking about the hull of the ship splitting in two, but perhaps a slow descent to the ocean floor.

I asked Simon about recent comments about creating a "soft Eurozone," and a "hard Eurozone."  He dismissed these as inoperable and wishful thinking. 

A tail risk, he said, was that Greece leaves the euro and re-establishes the drachma.  One of the factors which makes this not too difficult is the fact that very little Greek debt is held by external creditors, so that there would not be protracted negotiations about revaluations.  Capital, he said, has already flown, so that is not a big issue either. 

This led to a very interesting discussion with the Mancunian Simon who graduated from University College, London, where he lives. London property values are at record levels, which is not the case in other areas like the Midlands. Why?  French investors are now looking for safety in real assets, and London property is a ferry boat ride or puddle jumper away.  He talked about the London football clubs, like Chelsea, Arsenal and QPR, as being safe, real assets which are fun to own!  I wonder if this means a French consortium bid for Spurs? 

In the tail risk case where Greece were to leave the euro is a somewhat orderly way, Derrick feared the domino effect which would result in Ireland, Spain and Portugal leaving also.  At the same time, he said, the current euro system had "devastated" those economies in terms of resource misallocation, so leaving might be the best long-term strategy.

I couldn't finish my salad, but this presentation was definitely food for thought.

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