World Growth Concerns, ECB Refi, Euro-Yen Woes

The market has been well aware that last year’s massive 442 bln euro 12-month repo operation by the ECB, which accounts for a little more than half of ECB’s outstanding 870 bln euro of liquidity, was set to expire this week, however the situation is getting a bit more acute. There has been underlying concern that banks in the periphery of Europe are particularly vulnerable because they have come to depend on ECB funding. Banks from the periphery of Europe appear to have taken about 45% of the 12-month funds. The ECB will offer unlimited 3-month funds and a special 6-day operation as well.

However, this will shorter the maturity profile which forces the banks to have to keep coming back to the market or try to secure long-term financing, which in current market conditions is particularly difficult. Market talksuggest that demand for the 3-month facility could reach 200-250 bln euros. Where would the rest of the funds come from? Some suspect that some of the 304 bln euros that banks have deposited with the ECB will used. Banks also seem to be trying to raise some funding in the market and Euribor continues to creep higher. Ironically, the ECB is wrestling with both its credit easing strategy of buying sovereign bonds, of which it bought 4 bln euros worth last week, the same as the previous week, which is the lowest so far in the program’s seven week history, but also trying to exit its long term refinancing operation. The unwinding is the market’s immediate focus.

As the second quarter has wound down, the fear that the global economic recovery is losing momentum has resurfaced. That story today finds a foothold in Asia. The Conference Board’s revised its measure of China’s LEI from 1.7% to 0.3%, which is the smallest gain this year. It plays on fears that the world’s fastest growing economy is set to slow. Japanese data was simply dreadful. First, the unemployment rate unexpectedly rose in May to 5.2% from 5.1% in April. The consensus had expected decline to 5.0%. May’s industrial output had been expected to be flat after the 1.3% gain in April, but instead declined by 0.1%. The most disappointing report, however, was overall household spending which fell 0.7% on a year-over-year basis in May. The consensus had expected a 0.3%-0.5% increase. Yet the market had some inkling as the recent report showed retail sales plunged 2%, their biggest drop since early 2005. While deflationary forces are generally recognized in Japan, it does not simply imply falling goods prices, but wages as well. Japanese wages are off 2.4% year-over-year and this seems to also depress consumption.

The US financial regulatory bill that had been approved by key House and Senate committees at the end of last week and encouraged risk-on activity before the weekend has had a setback. The death of a key US Democrat Senator jeopardizes the finely balanced politics. Essentially 60 votes are needed to overcome attempts to block the bill. A Democrats successor will likely be appointed by the Democrat governor of Virginia, but it may not be until next week. In the meantime the opposition is not standing still. Some Senators that initially support the bill, like Massachusetts Senator Brown, is reportedly considering voting no. In addition to Brown, there are three other key Republican Senators, the two from Maine and Grassley from Iowa. On the Democrat side, pressure may build on Cantwell from Washington and Feingold from Wisconsin. They both oppose the bill on the grounds that it is not sufficiently strong. The bottom line here is that the bill is less certain than it was before the weekend and that uncertainty cannot be good for investors.

While the decline in dollar-yen may frustrate Japanese exporters, it is the euro’s slide that poses the greater financial challenge. Many Japanese exporters had internal budget level of around JPY95 for the dollar. The dollar is about 6.5% weaker. In contrast Japanese corporates had assumed the euro would be in the JPY120-JPY125 area. The euro is 10-15% below this. Contacts suggest that hedges may have offered some protection over the past three months, but many are set to expire at the end of this month or early July. The new hedges can be established but at much lower rates. However, new internal rates will likely be adopted and this may add to the pressure on the euro at the start of Q3. There is increased talk of the euro falling toward JPY100, though note that as the euro posted its record low against the yen early Q4 2000 near JPY89.