Euro View: How accounting funnies at Europe's banks could hit EUR/USD in December

Opinion: How accounting funnies at Europe's banks could hit EUR/USD in December and why markets are in danger of complacency over 2018's election in Italy. 

Euro-to-Dollar rates are seen moving higher over the coming quarters, thanks to a strong increase in Eurozone growth momentum, but the recent flurry of strong data and bullish predictions risks seeing markets lose sight of two key potential-pitfalls in the road ahead.

The Eurozone is on course to grow at its fastest pace since before the debt crisis in 2017 and, with the European Central Bank already having begun to saunter toward an exit from its quantitative easing program (bond buying), sentiment toward the common currency has continued to improve throughout the second-half.

German GDP was shown Thursday to have grown by 0.8% in the third-quarter, placing the economy on course to growth by 2.3% for 2017 as a whole.

“The entire Eurozone has done well in economic terms, increasing its attractiveness as an investment destination,” says Hans Redeker, head of global foreign exchange strategy at Morgan Stanley.

The broader Eurozone is also seen replicating this number for the current year and forward looking measures of business sentiment and expectations all signal that this momentum could continue well into 2018.

“With equity and FDI inflows are on the rise and with the RoW (rest of world) now under-allocated to EUR denominated assets, conditions for a significant EUR rally have stayed in place,” Redeker adds.

Accordingly, it might not be long before markets begin to bet on a faster QE exit by the ECB, or even that an interest rate rise might be likely earlier than previously thought.

“The dollar's correction lower towards equilibrium is likely to continue,” says Erik Nielsen, chief economist at UniCredit Bank. “EUR-USD remains undervalued and should approach its fair-value level of 1.25 by the end of 2018, supported by the ECB’s QE tapering and a return of portfolio flows in the euro area.”

Such bets by the market could see the already large number of strategists forecasting a EUR/USD rise to 1.2500, or above by end-2018, grow further still.

That said, there are still EUR/USD bears out there somewhere in the woods, including Bank of America Merrill Lynch and RBC Capital Markets, both of which forecast further losses for the common currency at various points in 2018.

Regardless, there are two events in the months ahead that are underappreciated and could test EUR/USD’s ability to hold or further recent gains.

The minimum that can be expected to come from either of these, or possibly both, is volatility in Euro exchange rates.

Above: EUR/USD at weekly intervals. Captures QE years and 2017 recovery.

Pitfall 1: Banks and Year-end Accounting Funnies

The system of European regulation that now exists, following a decade of post-crisis attempts to shore up the financial system, is vast.

“In the forward FX market, a pattern has come to recur with (un)pleasant regularity: The EUR basis widens out considerably towards the year-end,” says Ulrich Leuchtmann, head of G10 foreign exchange at Commerzbank.

“The reasons for this movement can be found in the USD liquidity needs of some market participants at the turn of the year.”

With the annual balance sheet date for most companies falling on December 31, year-end accounting funnies at Europe’s banks are a source of risk to Euro bulls in the short term.

To supervisors at the European Central Bank, bank balance sheets at year end are the main instrument through which they can measure the apparent riskiness of institutions under their watch.

Balance sheets themselves are best thought of as a photograph, or still-shot, of a company's financial position at a particular point in time.

To banks, those still-shots are an important channel through which they can influence the regulator's perception of risk lurking beneath the surface of the institution’s proverbial water.

“The EUR-USD basis has widened out significantly again in the last few days,” says Leuchtmann, in a recent note. “Similar to what we saw in late 2015 and late 2016, this development should be owed to a large extent to USD financing of European banks.”

Above: EUR/USD at 4-hour intervals during December 2016.

Regulatory perceptions of a bank’s riskiness are important because they will be used in the Supervisory Review and Evaluation Process (SREP) to determine how much capital said banks must put aside in reserve the next year (capital buffer).

The more capital that must be held, the less a bank will have available for distribution to shareholders as dividends and for deployment into new and profitable lending opportunities.

This creates an incentive for banks to dump risky assets ahead of the year-end and to buy safety which can, although not in all cases, lead to an accumulation of US Dollar assets.

Each quarter-end period is also important for banks in this way because it is the quarter-end financial position that is used to demonstrate compliance with the capital requirements that are already in effect during the year in question.

“This creates an incentive for banks to reduce at the end of the quarter any positions for which equity capital must be set aside,” Leuchtmann notes, referring to bank leverage ratios.

Above: EUR/USD, Dec 2015. Reaction to Federal Reserve rate hike and subsequent pressure.

The European Bank Levy, which is one-half a post-crisis punishment measure and the other half a precautionary planning measure, is calculated using the year end balance sheet.

“Positions that increase the levy base at that point in time are therefore particularly costly for the affected banks,” says Leuchtmann.

The levy commands a payment from banks, equivalent to a fixed percentage of qualifying assets, that goes into a collective fund to support deposit protections for customers.

Year-end accounting funnies are not always guaranteed to be bad for the EUR/USD rate however, and nonetheless, this seasonal trend is a risk for Euro bulls toward year end.

Above: EUR/USD, Dec 2014. Markets were also betting the ECB would launch QE at this time. 

Pitfall 2: Italy’s Election, Lessons from Farage and Brexit

After the failure of Marine Le Pen and the Front Nationale election campaign in France during, as well as the earlier routing of anti-establishment forces in the Netherlands, market fears of contagion coming from 2016’s Brexit vote have dissipated.

“The last significant remaining obstacle on the political front is Italian elections, likely in Q1 (and at the latest by May). Importantly, the bar for maintaining perceived political stability in Italy may be lower than feared,” says Yianos Kontopoulos, a strategist at UBS Group.

Those fears appear to be dissipating further still with the passing of an electoral reform law in Italy that has been seen to the reduce the chances of the anti-establishment and anti-Euro 5 Star Movement seizing power in the Mediterranean country’s 2018 general election.

“This scenario has the lowest probability of happening, but it is likely to be perceived as the worst-case by financial markets, due to the risk of an unwinding of previous reforms and, potentially, the beginning of a debate to reform the EU treaties,” says Dr. Loredana Federico, chief Italian economist at UniCredit Bank.

Seemingly having learned from the failure of Marine Le Pen’s anti-Euro campaign in France, the 5 Star Movement, or M5S to go by the Italian acronym, has recently backpedaled on its push for an Italian referendum on the use of the Euro.

“This would require a strong showing by M5S, resulting in it winning more than 35% of the votes, which would probably be sufficient for the president of the Republic to give M5S the mandate to try to form a government,” Federico adds, referring to the prospect of an M5S government.

M5S now advocates a Cameron-like “renegotiation” of the European Union treaties with Brussels which, only in the event that negotiations fail, would lead to a referendum on the Euro.

“Political uncertainty ahead of the upcoming general elections is keeping Italian risk premia elevated. The core risk, in our view, lies in the possibility of a Eurosceptic coalition which could revive perceived risks around Italy's Eurozone membership,” says Lefteris Farmakis, another strategist at UBS Group.

At the crux of MS5’s concerns are the European fiscal rules, beefed up in response to the debt crisis, that have imposed austerity on Italy and vast swathes of EU countries.

“Nonetheless, a number of practical and institutional obstacles are in place. These arguably attenuate those risks suggesting that a tail outcome remains unlikely,” says Farmakis.

Few, if any, in the economics and strategy field now speak of the Italian election or the 5 Star Movement as a threat to Italy, the Eurozone or the Euro. This, and other recent events, could mean now is an appropriate time to ask whether markets are at risk of becoming too complacent.

After all, in the UK, the Pound Sterling has fallen more than 20% against its major rivals in the last two years, growth is moderating and uncertainty over what the future holds is much higher than it would be under ordinary circumstances.

In June 2016 the country voted to leave the European Union and is now in the process of departing the bloc, or so we’re told. It is arguable that this would never have happened if not for a single person heading a rag-tag party that has only ever, and very fleetingly, held one parliamentary seat.

The pressure heaped onto then-Prime Minister David Cameron by the UKIP leader Nigel Farage who, with an uncanny insight into the collective mind of the working class and the will to swim against the political tide, dominated and drove the debate inside Number 10 Downing Street ahead of the 2015 general election.

That domination was encompassing enough for it to see PM Cameron’s stance on the idea of a referendum switch, over a period of time, from “there will not be an in-out referendum”, to “it will be an in-out referendum".

This begs the question of whether ascendency to the highest office would actually be necessary for M5S to cause Brussels, and the Euro, another headache.

Irrespective of this, current opinion polls put M5S in first place as Italy’s largest party. Regardless of “electoral reforms” already in place, or any alternative coalitions that might be cobbled together in the months ahead, M5S will likely have a considerable presence in Italy’s upper and lower houses after the 2018 vote.

Surely, given this and the electoral dynamics that drove Britain to Brexit, M5S driving a more rebellious bent into the next Italian government’s politics and its position toward Brussels cannot be so easily ruled out?

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