April 12

Draghi on Eurozone ABS Market

Mario Draghi spoke today in Washington at an IMF press conference. The majority of his comments revolved around the Eurozone Asset Backed Securities(ABS) Market. Since the Davos Conference in Late January Mario Draghi has eluded to a possible quantitative easing program focused on purchasing asset backed securities from Eurozone banks. As the case for QE from the ECB becomes more concrete, Draghi is slowly letting out more details to describe the European Central Bank’s thought process.

To conceptualize what will happen here, think about the Federal Reserve’s purchases of Mortgage backed Securities. This bond buying is focused on buying mortgages and has the effect of lowering(tightening) the gap between government bond yields and mortgage bond yields. This ‘gap’ is known in securities markets as the “credit spread”. In times of stress on the banking system, credit spreads increase as more default risk is priced in.

For the Federal Reserve, buying treasuries decreases interest rates. Buying mortgage bonds decreases credit spreads, and encourages banks to lend because they can simply sell the mortgages to the Federal Reserve. The European Central Bank wants to focus primarily on increasing lending, and secondarily on lowering credit spreads. The side effect of this easing program will also bring down the EUR in FX markets.

It makes sense to think about this as a step by step process:

1. European Central Bank Telegraphs it Will Buy Asset Backed Securities
2. Banks Begin to Make More Loans, In Anticipation of Packaging them Into Asset Backed Securities
3. In Order to make as many loans as possible, banks lower credit standards and charge lower interest rates
4. Loans are packaged into Asset Backed Securities
5. ECB Buys these Securities from the Eurozone Banks
6.Process Restarts at Two

Throughout this entire process the affect on markets is an overall tightening of credit spreads, more liquidity for banks and most importantly a huge increase in lending. The US economy works so well because Wall Street connects firms and corporations to a vast pool of investment funds via the capital markets. Large firms have near immediate access to money through the bond and commercial paper markets. The US ABS market functions efficiently, connecting investors with ABS bonds that can include anything from packaged up credit card debt, car loans and corporate credit lines. Literally anything can be included in ABS, and that is why they are so vital. The Eurozone lacks a centralized point like Wall Street for corporations to access money. This is especially a problem for small and medium sizes business in countries like Spain, Italy and Greece that are too small to access the bond market to fund themselves.

In past ECB press conferences Draghi has referred to the Eurozone ABS market as “dead”, and this isn’t far from the truth as seen in the graph below. Since the 2008 crisis ABS issuance has almost completely stopped. It is Draghi’s hope that a program to buy Asset Backed Securities will be a huge encouragement for banks to lend to small and medium businesses(SMEs), package the loans into asset backed securities and sell them to the ECB.I maintain my view that any quantitative easing program from the ECB, in tandem with continued US economic performance will fuel a significant trend lower in the EURUSD exchange rate in the second half of 2014. From a trading perspective I continue to remain on the sidelines, but I will be selling EURUSD opportunistically with a tight stop loss and adding if declines develop marked by lower highs and lower lows.