On the basis of the survival «in fine» of the Euro through a constrained and massive indirect monetization from the ECB, what are the expectations for 2012 on foreign exchange, short-term rates, long-term rates and equities?
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In light of our scenario for the euro, we can actually provide some answers that we will redefine and refine in a forthcoming paper.
We believe that the European QE should lower the euro-dollar parity in a range of 1.10-1.15 at the end of the first half of 2012; knowing that the market might be tempted to seek parity. Anyway no one will be against (including Germany) this implicit devaluation of the euro because restrictive fiscal policies established over Europe will have to be soften (in return of the monetary policy and the ECB QE)
On the side of the monetary policy, we expect lower interest rates in the area of 0.25% -0.50%. The ECB has set aside in Q4 2011 the two stupid increases of 0.25% in April and July, which had set the REPO rate from 1.00% to 1.50%; Indeed, after the declines of 0.25% from 03/11 and 0.25% of 08 /11, the REPO rate finds its level of 1%. Again, the easing of monetary conditions ahead will help to offset the restrictive nature of fiscal policy.
More important than these lower interest rates and the anticipation of the next, it was decided at the monthly meeting a number of devices that improve the functioning of the interbank market and the liquidity situation:
The ECB has adopted a historic longer term refinancing measure to support bank lending and money market activity. It also decided to lower the threshold rating for certain securities as collateral ...
The weight of the LTRO (long-term refinancing operations) is increasing at the expense of MRO (main refinancing operations). The ECB will introduce refinancing operations beyond 1 year (already abnormally long for a tender) with maturities of three years, which will improve visibility for some banks to refinance their activity in the medium term. The impressive success of the 3-year LTRO of 21/12 which allowed to propose a record amount of $ 489 billion to banks is still not correctly interpreted by the markets (we will return to this event in an article that will extend our article on monitoring indicators in crisis)
The collateral provided by banks as guarantee in refinancing operations with the central bank will see its eligibility criteria more flexible. In other words, the quality of financial assets will be made less demanding. This will then allow banks to engage a larger portion of their balance sheets and improve their access to central bank liquidity
Measure unnoticed but oh so important, the easing of central bank reserve requirements. Be aware that as part of its policy of controlling the money supply, the Central Bank requires banks to hold minimum reserves placed with it and paid at the REPO rate. So far the amount of these reserves represented 2% of short-term outstanding customers deposits held in the bank liabilities. This percentage is reduced to 1%, freeing - I can assure you - a large mass of liquidity for banks that can be reallocated to the real economy.
All these measures which have been wrongly perceived by the markets as purely technical measures are in fact true monetary policy measures designed to significantly improve the functioning of interbank markets and the financing channels of the economy. They are probably more important and effective than a decision which would have been to announce so brutally direct monetization of massive debts from Italy and Spain in the same way than the FED. The markets have not yet fully understood, obsessed as they are like politics and economist by the idea that monetization will solve everything.
By cons, our scenario is based on a significant rise in core long rates in Europe. Up to 3.75% on the German 10-year against the range of 1.80% -2.30% in recent weeks and up to 4.25% on the French 10 years against the range of 2.90% -3.20% during the same weeks (thus a OAT-BUND spread that would tighten to 0.50% by higher rates). Monetization, even indirect, of buying massive Italian and Spanish debts will flow back 10 years Italian and Spanish rates sharply to 4.75% -5.50% against 7% and 6.75% today. It is normal that the European QE corresponds to a convergence of long yields through a rise of the long-medium term rate of the Euro zone : rise in the long-term rates on government bonds of countries in the core of the Euro zone (risk premium on assets denominated in Euro in parallel with the fall of the euro) and long-term rates on government bonds of the peripheral countries (first beneficiaries of monetization)
No significant recovery to expect on indices with a range of 2800-3500 for the CAC and a halted decline. Even if we do not exclude a transition to the 2450, levels in March 2003 and March 2009 before these institutional changes start taking place and following new systemic fears coming from some sovereigns and among some names in the banking and insurance industry. Anyway, it will probably take a lot of stock picking and research on good exporting European stocks in the dollar zone (small caps to large caps and also the mid caps).
The Euro will therefore survive but at the cost of a much weaker parity against the dollar and higher long-term rates in France and Germany. All this in a near-zero interest rate environment and stock markets stabilized at low levels.
Mory Doré , December 2011
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