The summer of 2014 was less stressful for financial markets compared to the hectic summer of 2013. Easy monetary policy combined with increasing growth momentum in the developed world led to relief in the financial markets. The recovery of the UK and the US has met the expectations of a worldwide recovery, supporting the ideas of rate hikes starting in the first half of 2015. However, q3 results of China were disappointing and euro area momentum of recovery seems to have stalled. This causes foreign exchanges (FX) and interest rates markets to be a challenging environment for both corporate treasurers and central bankers. The conventional idea of a synchronized world economy as before the global financial crisis (GFC) seems to have been abandoned. We not only see economies grow at different speeds but also in total different directions. This unconventional macroeconomic divergence will create challenging but interesting times for the both longer and short term investors.
The US dollar (USD) has reigned supreme in the G10 in q3. Looking at year-to-date figures, USD strengthened in the G10 against the euro (EUR), Swiss franc (CHF) and Japanese yen (JPY) and has broadened to include the British pound (GBP) and the dollar bloc. In Asia ex-Japan (AXJ), the ‘divergence’ story has moderated in the wake of broad-based USD strength. However, the dollar has also accumulated. See graph 1
graph 1: Dollar appreciation
The strengthening of the dollar can be attributed to a number of factors. First of all the macroeconomic divergence, secondly the expected interest hikes in 2015, plus the rising US yields and yield spreads. With on the background the underperformance of the euro area combined with the European central bank (ECB) continuation of its highly accommodative policies.
While the US macro story is uninspiring by historical standards, it is better than its peers. Moreover, the dynamics of the USD have changed. The USD is turning from a counter-cyclical currency in the 2000s to a more pro-cyclical currency. Looking at real effective exchange rate (REER), we can even conclude that currently the dollar is undervalued and we might expect further gains. The current macro divergence is changing the game for the USD. See graph 2.
The euro story
With current policy rates near the zero boundary, monetary reflation strategies require a non-standard approach. This would be either the introduction of negative rates or the creation of excess reserves by providing banks with access to cheap liquidity. See graph 3 for the need of reflation.
Both measures tend to weaken the domestic currency by increasing supply of this currency in international money markets. Since Liquidity tends to support asset markets the ECB is introducing non-standard measures. The EUR declined within a positive risk environment.
This has led to a sell of EUR in the past months, See graph 4. Inflation expectations need to recover. If not, Japanification may convert from a bond-market theme to one for equities also. It is no accident that 30-yr Bunds are trading below 30-yr JGBs.
Bear in mind though, that the current weak EUR/USD positioning is unlikely to be a major obstacle for further EUR weakness. Mainly due to the euro area’s persistently weak macroeconomic backdrop. The region its economy is weak not only on an absolute basis, but also on a relative basis compared to the US and elsewhere in the G10. Divergence is a major negative for the EUR.
Looking at the valuation metrics, the latest OECD purchasing power parity (PPP) data suggests that EUR-USD ‘fair value’ is around 1.29, a little higher than current levels.
However, CPI-based PPP suggests EUR/USD is still overvalued versus its ‘fair value’ of 1.14. While PPI-based PPP suggests it’s fair value lies at 1.21. Due to the consistent weak economic performance of the Eurozone and the necessity for non-standard reflation methods by the ECB, I remain bearish on the EUR and maintain a bearish view on the currency for both the short and medium term.
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Gelein has been interested in the financial world and global economics since high school. For over 3 years he has been a member of a university investment team, of which one year he was the treasurer.