Friday Podcast 25th October 2013
Transcript of Podcast
The INR that had weakened to record lows against the USD in August 2013 should gain comfort from the strong Euro as it signifies rising risk appetite in the market. The Fed is still months away from tapering bond purchases given the US debt ceiling issues and that should lend further strength to the Euro. INR will benefit from this Euro strength and should see better days ahead.
The Euro has strengthened by 14% against the USD from lows seen in July 2012 to trade at two year high levels of Eur 1.379. The Euro was almost written off at the peak of the Eurozone sovereign crisis that saw Greece restructuring its debt while bond yields of Spain and Italy rose to unsustainable levels of over 7%. Coordinated efforts by the EU (European Union), IMF and the ECB led by the Eurozone’s strongest economy, Germany, prevented a collapse of the Euro and of indebted sovereign nations.
EU and IMF together extended loans to the indebted nations while ECB bought bonds and infused funds through emergency funding scheme auctions to stem the run on the Euro. ECB lowered interest rates to all time lows of 0.5% to provide cheap liquidity to markets. The result of the actions by the ECB, EU and IMF is seen in the strength of the Euro as well as the 250bps fall in bond yields of Spain and Italy.
The fact that the Euro has strengthened does not in any way suggest that the Eurozone economy is doing well. The economy is running at record high unemployment levels and GDP growth was at 0.3% for the second quarter of 2013. The economy looks to be limping back from recession with growth being negative in the last few quarters but is still very far away from even moderate growth levels. Indicators such as manufacturing indices and job additions do point to higher economic activity but sustained recovery is still highly elusive.
On the other hand, the US economy is growing at around 2% levels, job additions have been positive month on month for two years and unemployment rate has come off from highs of 10% seen in October 2009 to levels of 7.2% as of September 2013. However despite the better performance of the US economy relative to the Eurozone, the USD has depreciated against the Euro over the last 14 months.
The interest rate differential between the Fed and ECB rate is just 0.25% to 0.5%. Spread between ten year US treasury yield and ten year German Bund yield (German Bund is the benchmark Eurozone bond) is 80bps, which should be positive for the USD. The Fed is pumping in USD 85 billion a month into the system through bond purchases while the ECB is ready to buy bonds in case of any market volatility. The case for the Euro strengthening on growth or rate differentials with the USD is just not apparent.
So why has the Euro strengthened? The strengthening is largely due to markets covering short Euro/ Euro assets positions and due to risk appetite coming back to investors. Bond yields of Spain and Italy at around 4.1% to 4.2% levels offers a spread of 230bps over the German Bund. Germany’s benchmark equity index the Dax, is trading at record high levels. Credit spreads as measured by CDS (Credit Default Swap) curves for Eurozone countries have come off sharply from highs over the last two years. Markets are funding the risk appetite with USD given the Fed’s easy money policy.
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