Sunday 19 February 2017

A bull market for the Euro?

Probably for most of the period since 2008 short Euros or some other EU catastrophe trade has been one of the most popular macro themes, at least amongst macro traders sitting in London, New York and sometimes Texas, who often coudn't fathom the EU being more than an economic project for the countries involved.
With the USD bull market since 2013 we have seen the Euro fall to quite an undemanding valuation level and within that the 'Deutsche Mark' to more or less to an all time low.
As per BIS REER data:
We can see that the US Dollar hasn't really been stronger than now since Nixon ended the effective gold standard in August 1971 and Volcker hiked interest rates to kill inflation in the early 1980's.
Equally the Euro was only really weaker immediately post-inception in the tech crash. The implied Deutsche Mark has never been weaker than currently, while the implied French Franc is as weak as it was in 2000 when the Euro went to 84c and again has never been weaker by this measure of 27 exchange rates.
So what possible catalysts are there to drive up the Euro against the Swiss Franc or the Greenback?

Euro strength

In the near term we have significant left field tail risk in the form of elections in France, the Netherlands (albeit its only a small country) and potentially Italy. There is a good chance of further stress and Euro and related asset weakness into this electoral cycle. Additionally the Germans are unlikely to agree anything major until after their elections in August.
So once this has passed, coming into late-Q3 and Q4 we really have two scenarios. One where the social welfare states are set to leave, which would leave the Eurozone as a German currency block, set against the fact that the Deutsche Mark has never been cheaper, and a more likely scenario where by Merkel or Schultz agree a pro-growth, pro-reform pact, enough to retain the potential leavers and which may well be taken positively by the markets.
In either scenario I would adopt say a 2 year positive view on the Euro.
In each scenario you would likely see assets flow from Switzerland back into the Eurozone.

USD weakness

So will the USD be strong or weak? My expectation is that when the market sees Trumpflation as hurting most companies margins, while benefiting wage earners, and benefiting a minority of companies (some manufacturers, commodity producers and exporters), they see a steepened curve to price in higher nominal GDP, but a Fed that continues a low rate/ behind the curve target rate policy of financial repression due to the terrible debt dynamics in the US, or with Yellen's replacement in Jan/ Feb 2018 being someone that indicates a politicised Fed that is likely to monetise deficits; then we see USD weakness start to set in
Additionally if the EU reflates then we will have all major economic blocks reflating at a time of more or less full employment. You can see on the REER chart above what happened to the USD the last time an extended period of stagflation was used to burn off a credit bubble, but below is a nominal chart.
Data Source:
While history never exactly repeats, the Eurozone could conversely end up being viewed as the best of a bad lot, which will be quite a change to the last 7+ years.

Who will be the first central bank chair to go?

Yellen, Carney or Draghi?

Yellen must be on Steve Bannon's enemy list. She has been central in continuing and reinflating the neo-liberal framework that almost collapsed in 2008. The majority of Fed forecasts have proved over optimistic and their solution has been more of the same medicine (low rates, QE) while Obama ran up a $9Tn plus deficit bill.

Her four year term ends in Jan 2018. What would her replacement offer? Well someone needs to pay for tax cuts and infrastructure spending... and its clearly not going to be regular tax payers.

Osborne's boy outlasted his boss. Having blown up an enormous real estate bubble in Canada, he was duly brought over to repeat the act, while Osbourne tried to cut the deficit.

Despite failing to raise interest rates with the UK economy growing, various lines in the sand being crossed, and numerous Brexit consequence forecasts being wrong, he is still in the job. One can only assume that the shrewd, do nothing, politician in Downing Street is retaining him as a useful pawn to sacrifice when needed.

He did whatever was necessary to keep the EU together, albeit together and without any structural EU-wide reform, that has ultimately benefited Germany and her intra-EU labour arb model, while hurting the social welfare states. The pushback from France and Italy is coming in the elections, while Martin Schultz, if he wins the German election, is likely to compromise to keep the EU in tact, question is, will Draghi be one of the compromises? That said reflation in the EU will require unorthodox policies and Draghi may be ready and willing.

Perhaps Super Mario will be the only incumbent seeing the next 12 months out.

Some thoughts on Europe in 2017

Germany refuses to change the status quo because the status quo suits their economic model whilst crushing the social welfare states. Germany wont give anyone a break including Greece or Brexit negotiations because it doesn't want any change. Germany needs an export surplus to the rest of the Eurozone to maintain domestic employment. As Germany switched their supply chain to East Europe they needed to increase their export surplus to southern Europe in order to maintain full employment.
But France, Italy are G8 countries that are losing manufacturing base and Greece, Spain, Portugal, Ireland have been left with high debt. UK lost manufacturing base but is now devaluing and will in my view impose tariffs under a hard Brexit.

This whole concept of 'Global Trumpism' is labour pushing back against global capital. This is now the zeitgeist in developed markets, things have changed in the last 12 months. Now the electorate is pushing back against neo-liberalism and we are seeing the age of neo-nationalism.

So in France and Italy this is labour pushing back against German exports. In Italy Beppe Grillo, an alt left candidate, and in France Le Pen, an alt right candidate, are the leaders who are driving this. On the labour vs capital debate they both say similar same things.

The only way to reverse this process of Germany taking manufacturing base is to try and reflate the German economy via sectoral (government) deficits, wage rises, push up European growth and maybe impose other structural reforms that make outsourcing more difficult. The alternative is Frexit/ Italexit etc. Frexit and Italexit I think are now unavoidable if the Germans refuse to reform.
So Le Pen is likely to win in Q2 in my view. Fillon has a financial scandal, a financial scandal involving an elite politician and government funds is exactly the wrong type of scandal in this political environment. Even if Fillon wins he has to ask Europe for reform. So the question for financial markets is whether the French electorate empower Le Pen to drive changes or Fillon. I now think that they will empower Le Pen. Her platform is to call a Frexit vote.

If she calls a Frexit vote for say September/ October 2017, you have stress guaranteed in Europe into that. The German elections are in August, so its unlikely any substantive discussions could happen before that. Europe will be facing an existential crisis that will be resolved by a narrow referendum vote. Similar votes (Brexit, Italian referendum, Trump have all gone for labour and against global capital). There has to be a market stress into that. If you think about where yields in Europe were in 2011 or 2012 there can be large repricings, irregardless of ECB buying. In any case there are many European assets the ECB is not buying.

My bet would be that France narrowly votes against Frexit, but then Le Pen goes to Brussels and demands reforms into year end. If she doesnt get the substantive reforms she calls another Frexit vote and this second time the French vote to leave, followed by Italy.

If she gets pro reflation, pro growth reforms then Europe rallies, afterwards. But before that I think we need European stress. It will take a crisis to force the Germans and east Europeans to agree. If she does not get reform then I think France and Italy leave the Eurozone, at which point the European project is in tatters. Germany will be the only net contributor in size after the UK and France leave... As such I think Germany has to cave in, but it takes a real crisis to force that.

That is my current view on Europe this year, just my personal opinion. It could prove to be an exciting year in the European political economy.

As a corollary, with extreme current speculative positioning, the problem with being short US bonds now is if there is a EZ crisis then US fixed income should counter-trend rally; medium term though I am sure that the US belly needs to price in 4-5% nominal GDP rates vs a Fed that is behind the curve, but slowly hiking.