Well yesterday went as badly as it possibly could for TMM, with just about the only thing right with yesterday's post being the title, as Mr T and the A-Team reminded them precisely why they try to avoid trading Euribor at all costs. The Baron Von Trichet was almost as hawkish as he could possibly have been, sending rates markets into a tailspin as memories of June 2008 flashed before the eyes of many a rates trader. But pain aside, what are the implications?
Ladies and Gentlemen, may we introduce the new (old) star of the G7 currency show: the Euromark. Ultimately, while currencies are driven by a multitude of factors, from Current Accounts to rate spreads to geopolitical events, over the long term, divergences from the Real Exchange Rate are largely explained by Real Interest Rate spreads, something TMM highlighted in their 2011 Non-Predictions with respect to their strongly held view that USDJPY is going nowhere fast despite the best efforts of punters to try and rally the USD (thus far, unsuccessfully). And it is in that respect that HMS TMM are viewing the U-ECB torpedo that sank them yesterday after heavy gun fire throughout the week from other quarters. While TMM and many market participants view an early hiking cycle from the A-Team as something of a policy mistake (more on this below) in terms of the Eurozone as a whole, it also demonstrates that unlike many central banks around the world (for example, the Fed, the Bank of England and most of the EM world) that their number one priority is monetary stability and preserving the value of the currency in terms of inflation. While some have argued that this is more about trying to impress the Germans after Darth Weber's exit, stage left, it seems to us that Club Med are being sacrificed on the altar of the Bundeathstar. That is very bad for the periphery, however, it is very good for a Euro that is increasingly looking like it is The Deutschemark under ERM. Because higher rates are entirely appropriate for the German powerhouse.
The below chart shows the EUR (orange line), the nominal 2yr swap spread (green line) and the 2yr real rate spread (white line). While obviously not a perfect fit (certainly amongst the noise in late 2008), from 2004 until early 2010, in broad terms, the real rate spread did a much better job of explaining the Euro's valuation than the nominal spread did, and from July 2010 onwards, similarly so.