The Euro, Capital Flows and Speculative Trades

Quantitative Easing is generally seen as being negative for the currency in question, and the evidence would seem to support this, albeit not in all situations (sterling, for example). The ECB certainly believes that to be the case, the rationale being that lower bond yields in the EA will prompt investors to seek higher returns abroad, so resulting in portfolio outflows and hence selling of the single currency. The euro has certainly depreciated, both in broad trade weighted terms and against the other majors, and in May was 9.5% below its trade weighted value a year earlier, incorporating a 19% fall against the US dollar and a 12% decline against sterling.

Yet we also know that short-term currency moves can be strongly influenced by speculative positioning, with traders shorting a currency in the belief that QE should  be negative for its FX value, which then sets up something of a self-fulfilling prophecy for a time , as any initial weakness then prompts further selling given that momentum trading appears to be the predominant style at the moment. Data in the Commitment of Traders weekly report from the CFTC ( incorporating  FX futures ) provides a useful guide to speculative  positioning, and from that it is clear that the market started to build a very large short position in the euro/dollar last autumn and one which increased further  following the QE announcement in January.  The position peaked at a  record high in late March, at the equivalent of €28bn, and has unwound sharply since  to currently stand at €11bn, the lowest in almost a year. So the  initial fall in the euro and recent recovery would seem to owe something at least to speculative trades.  It is also worth noting that the unwind of the euro shorts coincided with a strong increase in short yen positions and a fall  in the yen against the US dollar.

What about more fundamental drivers of the euro, as captured in the Balance of Payments? The first point to note is that the EA runs a current account surplus, largely reflecting a positive merchandise trade balance, and one which is growing; the surplus rose to €212bn in 2014 and amounted to €245bn in the twelve months to April 2015, the latest data available. That surplus would therefore generally put upward pressure on the currency unless offset by capital outflows, which brings us back to the ECB’s hope that QE will stimulate such flows.

There has certainly been a significant change in terms of net  portfolio flows. with a net outflow of €160bn in the twelve months to April 2015, against a net inflow of €50bn in the year to April 2014. Moreover, outflows do indeed tend to be in terms of bond purchase, with  EA buying of foreign debt instruments  amounting to €119bn in the first four months of this year alone, which alongside some modest selling of other assets resulted in a rise in total portfolio outflows of €109bn.  Yet QE has also been associated with a significant rally in European stock markets, and  the same period has seen portfolio inflows of €76bn,  including €96bn in equities. So since the announcement of QE the outflow from debt investors has been offset to a fair degree by the inflow from equity investors albeit still leaving a net  portfolio outflow of  €33bn in the four months to end-April.

Direct investment flows also matter, however,  and here again the first four months of 2015 have seen strong inflows, amounting to €86bn, offsetting outflows of  €35bn to give a net inflow figure of  €51bn.  So net capital flows in total (portfolio plus direct) are small  to date  this year and actually a net positive (€19n) which added to a cumulative current account surplus of €69bn implies a inflow of €88bn. The errors and omissions on the BOP data can be very large and there are other financial flows associated with the banking sector but on the basis of the available figures  it is difficult to build a case that QE has led to the flows anticipated by the ECB or on a scale which might have led to a significant euro weakness. It is early days yet, of course, and higher US rates later in the year may trigger greater bond outflows, or indeed an outcome from the Greece negotiations which is seen as negative for the single currency.



Irish wages reflect market economy at work

There are two official sources of information on Irish wages and salaries, both published by the CSO.  One is an aggregate figure for the total paid out to employees and is published annually as part of the National Accounts . That series shows a modest increase in average pay over the past few years ( dividing total pay by annual employment ) which is at variance with the other data source,  a quarterly survey of employers across 13 industry sectors, which is also used to calculate total labour costs i.e. adding items such as employers’ PRSI.  The quarterly figures are also used to compile an annual data set and the CSO recently released the 2014 results.

Average  earnings came in at €35,768 per annum , marginally (0.2%) down on the previous year which in turn had seen another modest fall of 0.7%.  Pay peaked in 2009 at over €36,800 so the past five years has seen a fall in excess of €1,000  or 3%. Remember this is gross pay and takes no account of changes in tax and PRSI, and the average tax rate has risen over that period. Consumer prices are also higher, by 4%, so real gross pay has  fallen by almost 7% with a larger fall evident in real take-home pay.

The average  earnings figure for the whole economy masks  divergence across sectors, as one might imagine in a market economy with no central bargaining mechanism. Earnings in industry, for example, rose by 3.6% last year and continued to rise through the recession, with the result  that pay in that sector is now 5.7% above the 2009 figure. Pay in Information and Communication has risen  at an even faster pace over the past five years, by 10.7%, with the financial sector also seeing a strong increase of 8.3%, although that was strongly influenced by a 4% rise in 2014. Employees in the retail sector have also experienced a rise in gross earnings since 2009, of 4.8%.  Pay is down across all other areas  of the private sector, however,  and the public sector has seen notable  falls, including 11.5% in Health, 10.6% in Education and 7.3% in Public Administration.

The 2016 Budget may deliver an increase in public sector pay but the general pick up in domestic economic  activity since 2013  is  already having a discernible impact on private sector earnings. Construction output has rebounded  and 2014 saw a 4.6% increase in average pay in the sector, following a  2.1% rise in 2013. Similarly, the upturn in tourism is beginning to benefit employees in the Food and Accommodation sector, with pay there rising by 3.4% last year. Indeed, total pay in the private sector as a whole rose by 0.6% in the year to the first quarter of 2015 (   one should note that the quarterly data is prone to substantial revisions) and the consensus view is that the next few years is likely to see average earnings on a rising trend given the pattern of employment growth and the steady decline in the unemployment rate, which is now under 10% from a high of over 15%. Some sectors are likely to do better than others, as is inevitable in  a market economy with a  flexible labour market, although  the  recent experience of the US and the UK  suggests that  the pace of growth in average pay is  likely to be  subdued by historical standards.

What’s driving bond yields up?

The ECB has been delighted with the response to its asset purchase programme, and indeed the initial reaction from  all asset classes, from bonds through to equities and FX, was both significant and supportive of the Bank’s attempts to stimulate economic activity. The ECB first announced its intention to buy  private sector debt last September, with the euro trading at $1.29, and the single currency subsequently declined to under $1.05  following the January decision to extend QE to government bonds and the  commencement of purchases  in early March. European stock markets rose sharply in the months after the January decision and bond yields continued the trend decline begun last autumn; Irish 10-year yields fell to a low of 0.65% and the German equivalent traded at 7bp, with negative yields prevalent in that market up to an including the 5-year maturity.

The picture looks rather different today.  Government bond yields have risen sharply amid very volatile trading, with 10-year yields in most markets back up to levels seen last October. German  4 and 5-year yields  are now positive again  and the major European equity markets have fallen by around 10% from the highs, with the euro also gaining ground, trading above $1.12.  QE is still  proceeding according to plan and the ECB’s balance sheet is expanding as intended ( €2.42 trillion at end- May from €2.15 trillion at end-2014)   so the fall in asset prices has prompted some  puzzlement, with  a number of  explanations vying for supremacy.

One approach emphasizes  bond  fundamentals, starting with real interest rates and the outlook for economic growth. The  macro data in the euro zone has tended to surprise to the upside in recent months and there was some modest upward revisions to near-term growth forecasts  but the consensus projections for the next few years have not really changed, with most still expecting a sub 2% expansion in the EA.  Similarly the outlook for the global economy has not materially changed (if anything,  the growth forecast for this year have moved lower) so it does not seem likely that real interest rates have suddenly moved higher.

Nominal bond yields are also determined by  inflation expectations (plus a risk premium) and again  forecasts  for EA inflation have not materially changed of late, including those from the ECB,  which foresees a gradual return to annual inflations rates approaching 2%.  Actual inflation has turned positive, it has to be said, so perhaps the deflation scare has abated, although it was always difficult to know if that was really a major concern for investors. Expectations on one of the ECB’s most closely watched measures (the 5 year five year forward inflation swap) are  around 1.75%, which is well up from the sub 1.50% lows but not signaling any inflation scare.

Some peripheral bond markets have fared worse than others during the sell-off  (Portugal for example) but a generalized contagion from Greece is not evident, at least not yet, given that 10-yr bund yields  have also risen sharply, by over 80bp in the past 6 weeks.

Other explanations emphasis market conditions. Issuance in some markets has been higher than expected, for example, including corporate debt. Lack of liquidity may also be  a factor, as a consequence of banks having to hold more  regulatory capital. This , alongside the Volckler rule, has persuaded many market-makers to hold less inventory, with the result that a given degree of selling will have a much greater impact on the market price than it would have done a few years ago. Certainly the scale of intra-day volatility (up to 16bp in 10-year bund yields) is far higher than normal, supporting the idea of thinner markets.

Another  explanation highlights the different types of bond buyers, each with varying risk  tolerances and trading objectives. Banks are required to hold more liquid assets under new Basel regulations, and  so  have bought shorter-dated bonds even at negative yields , particularly as for some the alternative is a deposit with the ECB at an interest rate of -0.2% (overnight ECB deposits are still high, at  €100bn). Credit conditions are improving in the EA, however, with a modest pick up in lending to the private sector, so  some banks are finally using the ample liquidity available to support credit creation to firms and households.

Hedge funds and other traders are looking for a short term return and here the predominant  trading style may be a factor- momentum trading is the order of the day for many, which explains why a trend already well established can persist long after some feel it has lost touch with fundamentals.  The problem arises when the trend  changes and many are then heading for the door, which is suddenly crowded. The lack of liquidity  is exacerbating the downdraft.

‘Real money’ investors, such as pension and insurance funds, are also important, but usually ‘buy-to-hold’ and generally players at longer maturities. They are therefore  less likely  to get caught up in a specific trading style and may well step in following a sharp  sell-off, so putting a floor in the market.

All these explanations, fundamental and market related, are not mutually exclusive, of course, and I suspect the sell-off owes most to the  recent inflation data and the acceleration in monetary growth, with the exit from a crowded trade also playing a big role. One should also keep the correction in perspective- bond yields (government and corporate ) are still extremely low by normal standards and hence  nominal financial conditions  remain unusually  loose, even if a little tighter of late.  In the shorter term it may well be  the actions of  the Fed, rather than the ECB, that helps determine the next big move in EA yields.

Mortgage arrears model points to further decline this year

Residential mortgage arrears in Ireland are extremely  high, both in absolute terms and relative to comparable housing markets.  At the peak of the cycle , 130k  mortgages were over 90 days in arrears , equivalent to  1 in 7 of outstanding mortgages owed to domestic lenders.  In the UK the figure peaked at a little over 1 in 100 and  in the first quarter of  2015 the total amounted to just 114k, in a market with 11.1 million mortgages. The good news is that the  Irish figure is now falling steadily, and our arrears model points to a further decline this year, in the absence of a significant shock to the economy.

Residential mortgages have been treated differently to other assets by the Irish  banks.  Real estate and commercial property loans were sold to Nama in 2010 for 43 cents in the euro, so crystallising a €42bn loss for the banks and opening up a capital hole subsequently largely filled by the Irish taxpayer.  Residential mortgages were not marked to market, in contrast, and arrears built up rapidly, reflecting , inter alia, societal pressure against large scale repossessions, the absence of foreclosure on any scale in modern Ireland,  some legal issues, political unease and a reluctance by the banks themselves in an environment of falling property prices and capital constraints.

Arrears on Private Dwelling Homes (PDH) are largely driven by three factors. The most important is unemployment, as the loss of a job and subsequent hit to income is one of the main reasons why mortgage payments cannot be met. The numbers unemployed in Ireland soared during the recession, from under 100k to a peak of 325k in late 2012, with the result that arrears  climbed rapidly. Interest rates matter too, although the impact is not as significant, and the decline in  mortgage rates since 2008 has had some offsetting impact on arrears. A third factor is house prices, perhaps surprisingly, but the relationship is clear in the data; the fall in residential values from 2007 to 2013 was a factor in pushing up arrears , with the scale of negative equity appearing to influence the decision on whether to continue to meet the monthly mortgage payment.

All three factors , with varying lags, help determine the level of PDH arrears in our model, which has performed reasonably well in tracking the 2013 peak and subsequent decline; PDH arrears in the first quarter of  2015 had fallen to 74k (9.7% of  the outstanding stock ) from a high of 99k (12.9%). House prices are now rising, so putting downward pressure on arrears , but the main driver of the fall is the improvement in the labour market and accompanying decline in the numbers out of work. As noted, these explanatory variables enter the equation with a lag so we can forecast arrears forward, given the current level of interest rates, unemployment and house prices, and that points to a figure around 50k by year-end, or well under 7% of the PDH mortgage stock. All econometric equations have a margin of error, of course, and debtor behaviour can change, particularly in response to  an economic shock or a perceived change in the attitude of lenders. The last few months has also seen a marked slowdown in the pace at which unemployment is falling, which if sustained will impact arrears into 2016.

There is less data  available on Buy to Let  (BTL) arrears and there seems to be other factors at work, making it difficult to derive a parsimonious model. Arrears in this market are proportionately much higher than private homes, although they  also appear to have peaked,  albeit a year after PDH, and are also now declining ; the q1  figure was  27k ( 19.7% of the total stock) from a  high of 32k (22.1%). The different drivers in BTL are also evident from the decision by lenders to send in rent receivers in order to recover mortgage payments, with the total rising to 6k in the first quarter.

The improvement in the economy and the recovery in the housing market have therefore resulted in a brighter picture on arrears, although these  factors have also prompted a change of tack on repossessions ( the sale of loan books, a return to bank  profitability and  a new  financial regulator in Frankfurt  have no doubt also played a part). The flow  of properties into repossession has certainly increased, rising to 557 in q1 from 354 a year earlier ( half the total is voluntary ) and that figure looks likely to rise, given the reported numbers before the courts.