After a period of calm, Eurogeddon is back. The current form is a Cyprus headache. While it is a surprise to close watchers it has rattled markets. The reason seems to be the risk of deposit flight from weak to strong banks caused those who imagine that a deposit tax might happen elsewhere.
Australia did without deposit insurance for many years, and the Kiwis have (wisely) dumped it again, but in the context of the strongly unbalanced EUR banking system making deposits ‘at risk’ is likely to be destabilising.
The sell side research writes itself at this point. Re-cycle the charts about target-2 imbalances, talk about the limits to this system and the risk of break up, and then add a few lines about capital flight and circle the bits on chart when this last occurred.
The conclusion is fairly straight-forward. Folks exit the EUR for ‘harder’ currency options. They buy bonds in the US, CAD, SEK, AUD etc. This flow (or the anticipation of it) has sent the EUR down and EURUSD vol (1m) back toward the highs reached right after the Italian election — though this remains below the peaks reached in Q2’12, when folks feared a deposit run and breakup.
So does this matter for the RBA? I think that it does. The reason is that it reverses the ‘market easing’ that has given the RBA the scope to sit on the sidelines this year.
I think that the RBA expected to cut rates a little further at the end of 2012, however they have not had to do so this year. In part, this has reflected slightly better demand side data — however easier financial conditions have probably played a more important role than the modest pickup in domestic data. Easier financial conditions predict a later improvement in demand — so if sustained, the RBA would have had confidence that demand growth would improve further.
The main cause of the ‘market easing’ was a re-rating of risk assets (that began following Draghi’s convertibility speech mid’12, and was extended by FOMC’s move to open ended QE). Through this channel, markets have delivered an unusually large boost to household wealth and confidence, as well as easier finance and a lower cost of capital for firms.
These changes work a lot like lower rates (in some cases they are lower rates: such as tighter credit spreads) — by boosting wealth and confidence it boosts household consumption and by lowering the cost of capital and boosting expected returns, it lifts planned investment spending.
Both higher consumption demand and larger non-mining investment are a key part of the transition from a high mining investment economy to a ‘more normal’ economy. I had thought that the RBA would need to cut rates at any case to boost demand when mining investment declined (probably in 2014, if you believe the latest ABS capex survey), but had rolled my call on a near term easing as a result of the rude health of financial markets.
If this Cyprus debacle means that the market easing delivered by higher equity prices and tighter credit spreads is reversed, and business and consumer confidence follows equity markets down, the RBA will need to ease in the near term soon to keep things on track.
This will be especially the case if fresh bond inflows prevent the AUD from falling, as it ought to, when risk markets tank.