Higgs Boson and FX: What Matters

The scientists at CERN's atom smasher have reported discovering a new particle. The scientists themselves avoid calling it the "God Particle", though it does not stop the media. Essentially, this particle, called Higgs Boson, is believed to create an invisible field that gives mass to matter. 

Prior to the Big Bang, it is thought that all the particles did not have mass and moved around at the speed of light. The Big Bang changed everything. The Higgs Boson appears have been formed by two protons and it has a mass 100 times larger than would have been expected. This created an invisible energy field that is manifest as mass. Higgs Boson particles are believed to be the source of invisible energy that fills the vacuum in space. Some theories postulate several kinds of Higgs particles, yet to be discovered. 

The Higgs Boson makes matter, well matter. It is not always clear what makes things matter in the foreign exchange market. In our capitalist system, money matters. During "normal" times the price of capital matters most, but during the deleveraging crisis, access to money may matter more. 

In a move whose significance is not yet widely appreciated, the ECB quietly announced a far-reaching change on July 3. The ECB simply said that it would not accept any more government guaranteed bonds as collateral. The statement was deceivingly simple, but will likely mark a new phase in the crisis. 

Until now, many European governments sought the least costly way to recapitalize their banks. Banks would issue their own bonds, secure a government guarantee for them, and then use them as collateral to borrow from the ECB. This is triage. The losses the banks have incurred do not have to be realized. Owners and creditors are kept whole. Bank management is left intact. Real and necessary restructuring does not take place. Thus we have the emergence of "zombie banks" that are kept alive only by access to ECB funds and/or emergency lending by their national central banks. 

One notable exception to the ECB's new collateral rule is that EFSF/ESM bonds. These still can be used as collateral. 

What appears to be a minor technical rule change regarding collateral means that this strategy must end. The ECB wants countries to recapitalize their banks properly, but has limited tools to impose its will. And this all, of course, is taking place, prior to the ECB's new role as regulator/supervisor of euro area banks. 

The ECB wants a proper capitalization program and/or restructuring that requires realization of losses and equity capital infusion. The new rule limiting guaranteed bonds as collateral to the current amount blocks one path that countries have sought to avoid those hard decisions. For example, when Dexia needed assistance last year, it received 55 bln euros in guarantees from the French, Belgian, and Luxembourg governments. It took the guarantees to the ECB to borrow more funds, without the underlying situation from being addressed. 

The first country that may feel the effect of the ECB's decision could be Slovenia. The largest shareholder of Nova Ljubjana Banka (NLB), who turns out to be Belgium's KBC Group, is not willing to inject more capital into the bank. The Slovenia government may have been tempted to guarantee some bonds so NLB could raise funds from the ECB, the way that Italy recently did for its third largest bank. The ECB blocked this route. 

There may also be a wider effect. Italian and Spanish banks rely heavily on repackaging their own loans into securities and then using those securities as collateral to borrow from the ECB. This practice may also be adversely impacted. 

The ECB's move will further squeeze what appears to be a shortage of collateral. Financial shares in the euro zone had responded well to the rally in sovereign bonds and the prospects of direct borrowing from the EFSF/ESM emerging from the end of June EU Summit. The ECB's move on collateral may test investors resolve. 

This comes as reports have surfaced indicating that more time is needed to finalize the backstop of Spanish banks. Previously, it had been hoped to be finalized on July 9th. Now it looks like July 20th is more likely. Barring a surprise from the ECB, either a larger (50 bp) rate cut or no cut, the collateral rule change will likely be the subject of questions by reporters at the press conference that follows. 

We argued recently that the liberalization of ECB's collateral rules in late June to include different asset backed securities was tantamount to an easing of policy. This dovetailed with the end of the roughly three week upside correction in the euro that began with the key reversal on June 1, after the disappointing US jobs data. While this new decision by the ECB is restrictive, it is not euro supportive because it is likely to intensify the pressure on euro area sovereigns and deter investors. 

One doesn't need the Higgs Boson particle to know this matters.