Iggo's insight - When The Wind Blows

Iggo's insight - When The Wind Blows

08 September 2017

Forecasting exchange rates is, to make a massive understatement, not easy. However, there is a temptation to expect markets to continue to move in the same direction and a narrative that “back-explains” something that is used to “forecast” future moves. The euro-dollar exchange rate might be a case in point. Few would have forecast a rate of $1.20 at the beginning of the year when expectations of Fed tightening and a fiscal boost in the US would have underpinned positive views on the US currency. Now that the euro has appreciated by over 20%, the narrative is that it will keep on doing so. It might be time to take the opposite side of that trade.         

Less easing, but not yet

The European Central Bank (ECB) did not provide any details about the next stage of its asset purchase programme. For now the ECB keeps buying bonds and creating excess reserves in the euro-system, which means short term rates will remain negative for a long period to come and bond yields will struggle to rise. Furthermore, the ECB revised down its inflation forecasts for 2018 and 2019, possibly driven by factoring into account the strength of the euro exchange rate since earlier this year. So the central bank is still very much in easing mode by adding to the stock of bonds that it holds on its own balance sheet. While Mario Draghi did not talk about tapering, the market expectation is that the ECB will reduce the amount of bonds it buys on a monthly basis to perhaps €40billion per month from January onwards, from the current level of €60billion per month. More details will be announced in October. The sequencing remains the same in that bond purchases will be reduced and interest rate increases will come long after that with the market looking at mid-2019. What I find interesting is that some of the commentary around the ECB’s proposed reduced pace of buying describes this as a tightening of monetary policy. I know it is just terminology, but the balance sheet will still be expanding, excess liquidity will still be rising and interest rates will still be negative. This is not a monetary tightening, it is less easing. To me, that is not a reason to look for further euro appreciation after a 23% rise in the euro/dollar exchange rate since the beginning of 2017.  

Fed tightening, but slowly

Think about the US side of the relative monetary policy equation. Peak ECB easing might have been reached but on the other side of the Atlantic the Federal Reserve (Fed) has actually started to tighten. So far this has been modest increases in the Fed Funds rate (+1% so far). Next up is the beginning of balance sheet reduction which will gradually reduce the stock of bonds the Fed holds and will reduce the level of excess reserves. If the Fed is able to meaningfully reduce its balance sheet in 2018 and the ECB merely moves to a marginally lower rate of bond purchases, the relative positions of the two central banks will be quite different in a year’s time to how they are today. If it was monetary policy moves that were always responsible for exchange rate developments then investors would be looking at dollar strength rather than euro strength. If one believes that over time relative monetary conditions will determine exchange rate movements then “shorting” euro/dollar would be a very attractive trade at the moment.       

Sentiment drives the narrative

However, it is clearly not just about monetary policy expectations or actions. Other factors are responsible for the strength of the euro and the relative weakness of the dollar. Let’s think about market sentiment. When I was in Switzerland in January, a key theme amongst investors was bullishness on European equities. You can’t turn on Bloomberg TV these days without some fund manager talking positively about European stocks. The macro environment is improving in Europe with growth up and unemployment down and inflation in positive territory (at least). Credit and banking risks appear to have diminished markedly in recent years. On the political side, we have a reform minded President in France, that did not seem likely even a few weeks before the elections last May, and (probable) continuity in German leadership. As for the United States, initial optimism about President Trump’s economic agenda has pretty much evaporated in recent months. There has been no tax reform, the political atmosphere in Washington , D.C., appears to be poisoned and there is a huge amount of uncertainty about President Trump’s decision making on both the domestic and foreign relations fronts. I can’t speak for stock market investors but one narrative seems to be that the US market is frothy and built on overly optimistic earnings expectations in the technology sector while Europe’s stock market performance is explained by genuine recovery in top-line sales and margins.

What about political risks?

It’s tempting to take the other side of the consensus view. I’ve already described how the relative monetary picture could favour the dollar. What about sentiment? Europe may have a lot going for it right now but you don’t have to think about it too much before concerns are raised about Italy and what might accompany its election early next year. Last week, Catalonia voted to go ahead with an independence vote, setting the regional government on a collision course with Madrid and Spain’s constitutional judiciary. Brexit might be seen by most as being a particularly UK issue but there are two sides to what is a very large trading relationship. Lastly, what does a euro/dollar rate at 1.20 or 1.25 or 1.30 imply for corporate earnings in the euro area? Many Draghi watchers expected him to “talk down” the euro as its strength was seen as delaying Europe meeting its inflation targets and therefore extending the period for which asset purchases will be required. There must be an inherent fragility in macro expectations for Europe if the economy can’t cope with an appreciation of the currency that only takes it back to where it was in late 2014.

US growth advantage

Meanwhile, the US economy continues to perform well. Recent data show that GDP growth was 3.0% in Q2 and some economists are tracking growth at between 2.5% and 3.0% for Q3. Jobs continue to be generated and manufacturing indices are booming. There will be some disruption to the short term economic data caused by the hurricanes but in time that will be offset by the fiscal boost that will be required to rebuild property and infrastructure in the worst hit areas of Texas and Florida. Indeed, Congress and the President agreed this week to delay the debt ceiling discussion until December in order to deal with the mobilisation of Federal help for the emergencies in the southern states. While anything is possible with this President, I doubt there can be any further disappointment on the ability of the Administration to secure tax reform any time soon. One thing that may continue to impact on sentiment is what is happening at the Fed given this week’s news that Stanley Fischer will step down from the role of Vice-Chairman a few months early. His departure is clearly a massive intellectual loss to the Fed but it also means that there are a number of appointments to the Board of Governors that the President will need to make in the months ahead, including the replacement of Janet Yellen. I should think that there are enough advisors around Trump to dissuade him from taking any blatantly political decisions with these appointments, given the risk to the Treasury market and the dollar should he do so. However, it remains to be seen what the make-up of the Federal Open Market Committee (FOMC) will look like in what will be a very important period for monetary policy as the balance sheet is wound down.  

What goes up….

The euro/dollar rate is close to a 50% retracement of the decline it suffered during the mid-2014 to mid-2015 period. A full recovery would take it back above $1.35, a scenario that would likely trigger another euro crisis given the impact it would have on growth expectations. I certainly don’t expect to see those levels. The Fed’s shift towards normalisation, some fiscal boost in the US and an economy which has no spare capacity left, and therefore is much more likely to generate inflation than Europe, provides some textbook reasons for a stronger currency. Now, I know forecasting exchange rates is, more often than not, a mug’s game. However, after large one-way moves and when sentiment is pretty much in the same direction, you often get reversals. What I am saying here is that I don’t buy into the “euro keeps appreciating” story and would not be surprised to see a lower euro/dollar being one of the more surprising market moves of the next 3-6 months.   

Game of clones

It’s heartening to think that the future of the UK and European Union’s relations are in the hands of two, middle-aged, grey-haired  establishment men. I doubt anyone is any clearer on what the future looks like despite months of negotiations.  Meanwhile the two main political parties in the UK seem to be riven with disagreement on hard/soft/no Brexit and what any of that actually means in terms of trade agreements and immigration policies. It’s difficult to make come to any strong investment views on gilts, sterling credit or the pound because there is no conviction on any particular scenario, other than ongoing uncertainty. Thankfully, the UK markets benefit from the same forces that have continued to support markets everywhere – liquidity. Long last liquidity.

And now…

Back to proper football after the tedious international break. It will be interesting to see if the momentum of the first three league games of the season can be sustained this weekend and how the English teams will fare in the first Champions League matches next week. What encourages me about Man United this season is the strength of the squad. People like Carrick and Herrera have hardly featured so far and there are a number of choices all over the park. The weather has turned worse, the kids are back to school and college and the level of work intensity has ratcheted up compared to the August lull. Thankfully, there is Match of the Day and Sky Sports. Bring on the weekend.

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