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.

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