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The FX market needs to rethink inflation

Though you wouldn’t think it to see the way the market reacts, inflation is bad for currencies. If your prices rise relative to other countries your currency needs to fall to . equalise prices. Countries with high inflation have typically seen sharply declining currencies to offset the effect on relative prices. But typically, when inflation comes out higher than expected in the major economies, the market responds by pushing the currency in question up, not down. Why? Because the assumption is that the relevant central bank will raise rates to combat inflation pressures or not cut rates as much as it would otherwise, more than offsetting the move in inflation. Or at least that yields will rise to more than compensate for the rise in inflation. But the world doesn’t actually work like that, and hasn’t worked like that since at least the financial crisis and probably before.

The charts below show US and German CPI inflation plotted against real 3 month T-bill rates and real 10 year yields. If the FX market was right and central banks and markets responded to higher (lower) inflation with higher (lower) real yields, you would expect there to be a positive correlation between inflation and real yields. Broadly speaking that was the case in the 80s, though only broadly speaking. Not much happened in the 90s, with inflation and real yields broadly steady on a trend basis. But from around 2004 there has been a very clear negative correlation between inflation and real yields. Inflation has mostly fallen, and when it has, real yields have risen. Why? Because either central banks have had more pressing concerns than current inflation, as was the case immediately after the 2008 crash, or because they reached a lower bound in yields preventing them from reducing real yields any further, so effectively nominal rates were fixed. This means that a decline in inflation has, ex post, actually made a currency more not less attractive for the last 10 years.


Source: FRED, FX Economics

Now, it may be that there will come a point where central banks and markets start to react to higher inflation by pushing real rates up. In the US, this may not be too far away, but it still looks a long way off in the Eurozone and Japan, where higher inflation would be seen as a good thing and won’t be offset by higher nominal short term rates, never mind higher real rates. Although the markets may allow longer term yields to rise somewhat, it is still doubtful that rises in inflation will be offset by higher real yields (i.e nominal yields rising more than inflation) in the near term. Even if they are, the point about higher nominal yields is that they compensate the FX market for the decline in the currency that will happen because of inflation. A rise in inflation accompanied by an equal rise in yields should in theory have no immediate effect on a currency. The currency should be expected to be a little weaker going forward because of higher inflation, but the investor is exactly compensated for the lower expected value with higher yields.

So why do FX markets react as they do? Because it is clear that they see higher inflation as a positive thing for currencies because of the perceived implication for yields and central bank policy. It may simply be money illusion. That is, higher inflation, will at the margin, mean higher nominal rates, but at this stage and for the last 10 years this has not meant higher real rates, as is clear from the charts. Or is it just that the market is stuck in some sort of 80s mindset imposed on it by people who have simply observed the past – i.e. that higher than expected inflation typically meant currencies rallied, so all the models (carbon and silicon) are programmed that way for evermore?

Whatever the reason, it’s time the market woke up and smelled the coffee.  Central banks are not straining at the leash to raise real rates to head off rising inflation. In fact, the (broadly) effective zero lower bound in nominal rates has meant many are hoping to get inflation higher precisely because it’s the only way they can get real rates lower.

So higher inflation should be seen for what it is. It is an effective real currency appreciation. Prices are higher relative to the rest of the world just as they would be if the currency had fallen. The proper FX market response to that is to reduce the value of the currency to equalise domestic and foreign prices accordingly, not to push the currency up in the expectation of a central bank response that isn’t going to come, and if it did wouldn’t fully offset the inflation move anyway.





Trump: the new Reagan for the USD?

EUR/USD (equivalent) under Reagan 


Source: FRED

Both have been involved in the entertainment industry and both are tax cutting Republicans. Beyond that many Reagan fans would see comparisons with Trump as an insult. But can Trump have a similar influence on the economy and the USD? Reagan’s presidency saw the USD embark on a huge roller coaster rise almost doubling in value against the DEM in 4 years before falling back to its starting level by the end of his presidency. Can the same happen under Trump?

Reagan’s presidency was notable for its big tax cuts, strong growth and roller coaster move in the USD. Trump is also looking at a big tax cut and a big increase in infrastructure spending and they have the potential to mimic the impact of the Reagan years in broad brush terms. While there may be criticism of the efficiency and sustainability of his tax proposals, the markets will initially react more to the brute power of any fiscal expansion. All such efforts have a price and often end with a bad hangover, but by dint of its status as the global reserve currency and the global superpower the US is able to take fiscal actions that might be seen as reckless elsewhere without a major short-term risk.

How big an impact on the economy Trump will have will depend on how much of his proposals he can get through Congress. With a Republican House and Senate he is in a better position than Reagan was, who faced a Democrat House for his whole term, but nevertheless was able to push through some radical tax cuts. I am not going to go into too much economic detail about Trump’s proposed tax cuts and infrastructure spending, in part because his proposals are bound to change, in part because what he gets through may look more like the House Republican package than his current proposals. But it is worth noting that his election proposals involve around $7trn of tax cuts over 10 years and at least $550bn of infrastructure spending. His tax plans will likely be bargained down but even the House plan will involve a corporate tax cut to 20% and personal tax cuts. Some think that the economic impact will be modest, in part because a widening US budget deficit will push up yields and hold back private sector spending.This is possible, though in my view it will take quite a large move up in yields to have this effect, and with yields very low elsewhere rising US yields will make treasuries too attractive internationally for yields to rise too far.The infrastructure spending in any case looks to be the main agenda item for the first 100 days, and this will have a substantial direct growth impact. Tax plans will probably take longer to pass, but should also have a significant impact.

But even if the impact on growth is quite modest because of the impact on yields, the rise in yields will itself be supportive for the USD. We have already seen the start of this. It is here that the comparison with the Reagan presidency looks most apt. Not only are US yields likely to rise in response to more expansive US fiscal policy, the Fed were in any case set to embark on a steady rise in short-term rates. Meanwhile, yields elsewhere have much less potential to rise, with the BoJ locking 10 year yields to zero and the ECB debating an extension of QE rather than tightening. The Euro also looks likely to struggle under the same surge of ant-establishment political uncertainty that has helped to elect Trump, with elections in France and Germany next year and a significant referendum in Italy approaching. While these could also lead to more expansionary fiscal policies in Europe, eventually reducing EUR weakness, in the medium term the political uncertainty looks more likely to weigh on the EUR.

As a reminder of the impact of the Reagan presidency on the USD, the chart above shows the US 10 year yield spread over bunds and EUR/USD (based on USD/DEM). EUR/USD nearly halved from 1.23 in January 1981 to 0.67 in February 1985 when the Plaza accord was initiated to halt the rise of the USD.

There are a lot of questions about timing with Trump policies and the USD. Reagan didn’t really get many of his policies implemented until late 1982 after being inaugurated in January 1981, and the chart suggests this was the second leg up in yields after the first had been triggered by the policies of Volcker at the Fed. However, the USD started to rise almost from the moment Reagan was elected. Of course, some of this was down to Volcker rather than Reagan, who had come in under Carter and had raised rates sharply to bring down inflation. But anticipation of Reagan’s policies played its part. In the case of Trump, he may well get things through faster than Reagan, and with the Fed already primed to hike the USD seems likely to react immediately. It has already started.

In addition to the potential impact of fiscal policy on growth and yields, the Trump presidency offers the possibility of new Fed appointees favourable to his more hawkish preferences for monetary policy, and the intended corporate tax cuts could also lead to huge repatriation of funds held abroad by US corporations, both of which could exacerbate the USD boost.

Of course, there are aspects of the Trump presidency that may not be seen as being so USD positive. Severe restrictions on immigration could be expected to have a negative impact on growth, as would major changes in trade agreements. But it remains to be seen whether these “populist” policies will be implemented aggressively. While in theory the President can make changes to trade agreements much more easily than he can to spending decisions, Trump’s election promises may turn out to be negotiating positions. His post-election statements suggests some backtracking, but even if they don’t restriction of labour supply and restriction of imports could result in significant inflation and higher yields, possibly even boosting the USD further.

Of course, none of this represents an opinion as to whether Trump’s policies are good for the US or the world. The strength of the USD is not a barometer of good or bad policy. It’s a price, and right now it looks like it’s going up.



A crisis for UK democracy?


A bit on the markets in a minute, but first a bit of a rant.

If the Daily Mail call High Court judges “enemies of the people” simply for saying that parliament has to sanction the triggering of Article 50, what will it do if some MPs choose to vote against the wishes of their constituents?

This is a difficult issue for some MPs. After all, some are in constituencies that voted to Remain but themselves support Brexit. Others are in Leave constituencies but were in favour of Remaining. The Daily Mail would argue that the people have spoken with the referendum, but the result was close, and had more young people voted might have gone the other way. It might go the other way if it was done again today. So in my view MPs should vote in line with their own views. But they won’t. Even if they are in “Remain” constituencies, and are pro-Remain themselves, very few MPs will vote down a bill to trigger Article 50. Partly because they will be put on the front page of the Daily Mail if they do. And they remember what happened to Jo Cox. This is not a good way to govern a country, and reminiscent of some unpleasant regimes.

Unless MPs are prepared to act as responsible human beings and stand up to their party, the press and the noisy section of their constituents, they are becoming an irrelevance. They are mere ciphers. They are not being allowed to make their own decisions about anything important. It is important to have a role for personal conscience.

The further irony is that Brexit was (according to the Leave camp anyway) supposed to be about taking back control of our government from the EU. But if MPs are effectively just servants of the government, we are effectively being governed by royal prerogative. Come back Oliver Cromwell.

Anyway, rant over. The markets.

Sterling has managed a little rally in response to the High Court decision that parliament has to trigger Article 50, but this doesn’t look like it will be enough to sustain a strong rally in GBP for at least two reasons.

1) Although GBP is now a lot cheaper than it was, it is not dramatically cheap against the USD or the EUR given the big UK current account deficit and the lack of (real) yield attraction available in GBP.

2) Even if the High Court decision is upheld by the Supreme Court, it doesn’t mean no Brexit. Brexit is still extremely likely to happen. There might be some impact on the shape of the Brexit, but even this isn’t clear. If the government sticks to its guns on rejecting free movement and the EU sticks to its guns on making free movement a condition for single market access, it seems doubtful that parliament will really be able to have much real effect. What does seem likely (though not certain) is that there will be a significant delay in triggering Article 50 because of the time it is likely to take to put a bill through the Commons and Lords (average time one year). There could be a simple resolution to speed things along, but this would mean parliament would have to have its say at a later date.

So the vote has created extra uncertainty around Brexit, and has perhaps increased the chances of a softer version and a longer delay. This is mildly supportive for GBP, but some argue that the delay and uncertainty only makes things worse as firms are unable to plan for the future. I’d say this is outweighed by the increased chance of a softer Brexit, but not so much as to justify a dramatic GBP rally. EUR/GBP may manage to get back to the 0.86 area, but unless there is a lot more promise of a soft Brexit or some evidence on Eurozone weakness and/or UK strength gains beyond this are hard to justify. Still, it looks like it might be enough to stabilise GBP in the 0.86-0.91 range.

I have put this in terms of EUR/GBP rather than GBP/USD because coming into the US election the picture for the USD is obviously very uncertain. Most take the view that a Clinton victory will be USD positive, and market behaviour in the run up to the election suggests this is the case, but with a Clinton victory now priced as around an 80% chance, the market reaction may not be huge. The Fed is very likely to hike if markets respond positively – even neutrally – to the election, and that should be enough to sustain the USD against most currencies, though which currencies it gains most against will to some extent depend on the (uncertain) medium term equity market reaction to the combination of a Clinton win and higher US rates.

This is all pretty much the consensus view, and I’m not going to speculate too much on what happens if Trump wins, except to say that I’m not sure the impact will be that sustained. In the end, Washington will put fairly substantial limits on what he is able to do.

EUR weighed down by GBP not Draghi


Looking at the markets, it seems as if Draghi said that the ECB would be easing further come December, or at the very least March. The EUR has gone into a tailspin since the ECB meeting, and journalists are queuing up to blame Draghi. The trouble is, no-one seems quite sure what he said that triggered the move. One headline said “Euro close to 8-month lows vs dollar Friday after ECB chief Mario Draghi ruled out an abrupt end to QE.” Another headline “Euro wallows near March lows after Draghi quashes tapering talk”. So did he quash taper talk, or did he say the ECB would taper? Because if you don’t end abruptly, you taper (it’s one or the other). And which is better for the EUR? Because when it was suggested that the ECB would taper a month or so ago (by some unnamed committee member that Draghi emphasised had no insight) the EUR went up. So presumably if they don’t taper it goes down? Except Draghi said they would taper. Which I would have thought was sensible, and less likely to be EUR positive than an abrupt end to QE if anyone thought about it. Which all probably goes to show how silly the original “taper tantrum” was, but doesn’t really explain why the EUR has been so weak since Draghi’s press conference, especially since the effects of the initial taper tantrum were fairly short-lived in any case because on reflection most saw that the initial story didn’t mean a great deal, true or not.

In reality I don’t think the market really saw anything new in Draghi’s comments, but in the absence of anything new, the downtrend in EUR/USD remains in place. EUR/USD has been in a downtrend since the Brexit vote, and with the market expecting a Fed rate hike in December and currently seeing a probable Clinton victory as favourable (presumably because it is essentially the status quo – no nasty surprises), the burden of proof is now on those that want to oppose the EUR/USD downtrend. It is interesting that the Brexit situation appears to be the key factor that has pushed EUR/USD lower, though the UK is a small economy by comparison to the US and Eurozone giants. It is certainly the case that EUR/USD has never regained the 1.1377 high seen on June 24 and had been edging higher into the vote. It is hard to see that the economic news form the two economies since then has been particularly USD positive or EUR negative. If anything the opposite is true. Certainly since the beginning of this year the performance of the Eurozone in both growth and inflation has been broadly in line with expectations, while US growth has significantly underperformed. In fact, the OECD currently expect US GDP growth to be weaker than the Eurozone’s this year, and although many expect the Fed to raise rates in December, this is significantly less tightening than had been anticipated  at the start of the year.

So we need some change in market perceptions for the EUR to stop falling, at least until we reach the key levels in the 1.05-1.08 area in EUR/USD. A less negative view of Brexit from the perspective of both the UK and the Eurozone is the most obvious potential trigger, though that doesn’t seem imminent with the EU ruling out negotiation until the UK invokes Article 50, which most likely will be in Q1 2017. The other main possibility is a change in the perception of the Fed, though the way things have turned out this year suggests that even if the Fed don’t raise rates in December, the hit to USD strength may only be temporary unless the ECB turn out to be unexpectedly hawkish at their December meeting. The third chance of a Trump victory is one I hope we don’t have to consider.

Fed hike overpriced


The latest OECD forecast for 2016 US GDP growth is 1.4%. That would be the lowest since the recovery began – i.e the lowest since the -2.8% in 2009. It is also lower than the 1.5% forecast for the Eurozone, and lower than the 1.7% forecast for the UK. Yet the market is currently pricing a 70% probability of the FOMC raising its funds rate target by December, while all the talk is about when the UK will cut rates again and whether the ECB will ease again. Of course, current growth is not necessarily the prime determinant of the Fed’s decision. They are forward-looking, and focus on dual targets of inflation and employment, but growth is the major consideration for both these objectives, and while future growth is expected to be better, growth has disappointed all this year so forecasts of future strong growth require a degree of optimism. We have the Q3 GDP data for the US on October 28th. The consensus forecast is still around 2.7%, but the Atlanta Fed GDPNow model is currently showing a forecast of 1.9%. If we were to get another sub-2% growth number in Q3, the probability of the Fed tightening in December would surely dip sharply.

Of course, the reason most are looking for a December rate hike is not because they have done a deep assessment of the economic rationale and put a lot of trust in their forecasts of growth and inflation. It is because they think the Fed have said they will. The three dissents at the September FOMC notably included former arch-dove Eric Rosengren, and many see this as a signal that the Fed is preparing for a December move. But the latest speech from Yellen ought to cast a bit of doubt on this assessment. Yellen didn’t specifically indicate a policy intention, but she did suggest a possible willingness to try to run a faster economy in order to recover some of the lost output seen since the recession. As she put it – “If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a “high-pressure economy,” with robust aggregate demand and a tight labor market.” If she wants to try this, raising rates when growth hasn’t reached 2% in any of the last three quarters, as would be the case if Q3 GDP comes in sub 2%, doesn’t seem to be a sensible tactic. We certainly don’t have “robust aggregate demand” on this reading.

The tightness of the labour market is perhaps the best argument for higher rates. Traditional economics has tended to focus on the labour market as the main driver of inflation, as a tight market drives up wages and costs. However, there are three points to make on this. First, that although the US is no doubt close to full employment, the unemployment rate in the US hasn’t fallen in the last year, at least partly because of the weakness in growth. Second, average weekly earnings growth hasn’t been rising. If anything it’s been falling, with the 3 mth y/y average dipping below 2% in October for the first time since February 2014. Third, Yellen’s latest speech highlights that the labour market hasn’t really been the driver of inflation in recent years. As she notes “the influence of labor market conditions on inflation in recent years seems to be weaker than had been commonly thought prior to the financial crisis.” So although the unemployment rate is quite low by historic standards, it’s not falling and doesn’t appear to be putting upward pressure on wages.

As for inflation, the Fed’s preferred measure – the PCE deflator – is steady at 1% and hasn’t been above 2% since 2012. While oil price fluctuations may move it short-term, it is not currently an issue the Fed has to worry about. If anything, the concern is still to convince the market and the public that inflation is likely to rise from here. Recent years have proved that deflation is a much harder issue to deal with.

So I find it very hard to make a case for higher rates based on the current state of growth, inflation and unemployment, and the latest speech from Yellen suggests to me that she does too. The rate hike last December was based on much stronger growth expectations and some evidence that growth is moving back above trend looks necessary to me to justify another move. Given her recent speech I suspect Yellen feels the same.

Now, there are of course other arguments for raising rates. The side-effects of holding rates very low are generally perceived to be damaging, with savers penalised and asset owners rewarded. Inequality increases as a result. But this is a reason to want rates higher in the longer run, not necessarily now.

It will take a lot to change the market’s mind on the Fed, but it seems to me that the current 70% probability priced in for a (November or) December hike is overly confident. The Q3 GDP data may change this view, but it may require a Fed comment or two to move expectations even if the GDP data do disappoint, given the market’s current tendency to need to be led by the nose. Many on the Fed who want a hike clearly aren’t really basing it on the current behaviour of the economy.


GBP weakness overdone?

Well, yes and no. I think the lows seen overnight represent a reasonable idea of the base for GBP, but we may well have another look at them before we go higher. I would argue that while the bad news about Brexit is now broadly in the market, there are few reasons to buy GBP, and levels are still not that attractive, so I would still prefer the downside for now.

The overnight moves were clearly exacerbated by poor liquidity in Asian hours, though it’s still surprising to me that liquidity is that poor. It seems that in the new algo dominated world such moves are becoming more frequent, though it is more surprising in GBP than it was in the CHF when there was a clear change in regime in the removal of a floor. Exotic options structures may have been responsible, but I am not totally convinced by the explanations I have heard.

Anyway, GBP has bounced back after the sharp dip overnight, but buyers will now be even more wary than they were and the prospects of recovery consequently that much less. Was the weakness overnight justified by events? No, in that nothing changed dramatically enough to trigger such a sharp fall. Underlying concern about a “hard” Brexit is behind the negative GBP sentiment, but does this mean GBP is weak indefinitely until the reality of the trade arrangements are realised? Surely not, as we may see no clarity for years. What we are seeing from May, Hollande, Juncker, Merkel et al. isn’t even negotiation yet. The UK hasn’t even triggered Article 50. This is just the pre-negotiation posturing – the trash talk before the big fight. I don’t know what the trade relations between the UK and the EU will look like in the end, but I suspect there won’t be the radical step change in trade that some seem to think. The bad news of a “hard” Brexit is now essentially in the market, so may be there is no more to come and GBP has hit its lows. This is certainly possible, but the problem is that the pound still isn’t particularly cheap.

There is more than one way of assessing value in FX, but I will show three charts here to illustrate why I think GBP is far from being significantly cheap. It is broadly fair against the USD, but it is still expensive against the EUR. I have published these before back in June before the Brexit vote as reasons why, even if there had been a vote to Remain, GBP was too high.

The first chart underlines that GBP is still well above PPP against the EUR. While currencies don’t necessarily trade near PPP, it is a good starting point, and it can be seen from the chart that GBP has generally traded a lot closer to PPP against the EUR than it did in recent years. There was some justification for higher GBP valuation at the height of the EUR crisis, including higher UK yields and greater perceived security, but the yield advantage has effectively vanished and GBP now also looks more risky and less secure, so the justification for trading above PPP is much reduced.

Against the USD the tendency until the mid noughties was to trade close to PPP. Subsequent GBP strength may have been a result of reserve diversification by major central banks (among other things) but current PPP is around 1.32, so we are only marginally below there.

The third chart illustrates how major currency levels versus PPP generally correlate to the size of the current account deficit/surplus in each currency. On this basis GBP looks about fair, while the EUR looks very obviously cheap and the CHF exceptionally expensive. The relatively high valuation of the NZD and AUD reflect their higher yields. The cheapness of the EUR and the high level of the CHF suggests the CHF is the proxy DEM, but sooner or later I expect this will also be corrected.


Source: OECD, FX Economics


Source: OECD, FX Economics


Source: OECD, FX Economics





Value in SEK as market blinded by yield obsession

Back in the mid-noughties when I was working at RBS as their FX strategist, a couple of geeky guys came to see me. They wanted to know what the key drivers were of the FX market. I went through the normal parade of factors – value, terms of trade, yield spreads (real and nominal), politics, current account balance, risk appetite, momentum and so on, and tried to stress that the trick was deciding what they key factor was at any one time. But they asked me to pick what the most consistent driver was, particularly in the short-term, and I said yield spreads and risk appetite. I suspect they went away and built a high frequency trading model that may have made (or lost) the bank millions – these were the days when banks (especially RBS) liked to take risk.

Nowadays, I sometimes think that the whole market is trading this way, and has lost sight of all the longer term fundamental factors. Maybe everyone has gone away and built the same model, and the market has got locked into a world created in the noughties because everyone is trading as if the ideas that made sense then will make sense for all time.  But it all looks a bit outdated in the current market. Yield spreads are generally very small, and the risk characteristics of currencies can change. For instance, the EUR was a reasonably risk positive currency back in the noughties, but the Eurozone now runs the largest current account surplus in the world and has seen huge net capital outflow over the last year to balance it. This suggests a much more risk negative characteristic, and that has to some extent been the case.

But it is the focus on infinitesimal differences in yield spreads that is the hardest to justify, especially when looked at in comparison to valuation measures. Tiny changes in central bank rates are used to justify large moves in currencies which are already misvalued. This is partly because there is no agreed way of measuring correct valuation in FX. And while FX is essentially mean reverting (in real terms) the time taken to revert to the mean can be long. But with all rates close to zero in the majors and most of the G10, valuation really ought to become a much more important driver of FX, as it will take a very long time to make any money on the carry gained from holding, say, GBP against the EUR.

While there is no agreed simple way of measuring correct valuation, history does give a reasonable guide. Real effective exchange rates do provide a good guide to value relative to history, though it is always possible that something has changed to create a deviation from historic norms.  The G10 currency that looks most obviously undervalued relative to history is the Swedish krona. It is only around 5% away from all time lows, and is an illustration of how the market is driven by tiny interest rate differences which will not compensate for misvaluation in the longer run. The Riksbank have managed to drive the SEK down by setting negative rates, but the Swedish economy looks one of the healthiest in the developed world. Growth is likely to exceed 3% this year, inflation is only modestly below target, the current account is in significant (excessive) surplus, and unemployment is back down to pre-financial crisis levels. Despite this, the SEK is second only to GBP as the weakest G10 currency this year, presumably because of the combination of low yields and its undeserved status as a barometer of European risk sentiment. This seems to relate to the fact that Sweden is a small open economy with the Eurozone as its biggest trading partner, so can be expected to suffer both negative growth and current account impacts from weakness in the Eurozone. However, the Eurozone is not that weak at the moment, and Sweden seems to be doing fine anyway. The only problem that people seem to be able to point to is excessive household debt and an inflated property market, but Sweden are hardly alone in that, and the SEK offers much better value that those in a similar boat (the UK, Canada etc.).

It may be hard to hold onto a long SEK position because gains are likely to be slow and it can be vulnerable to negative risk spikes. To guard against his it may be worth holding a basket of long SEK vs GBP and EUR, though I would probably prefer to short CHF than EUR.

Here’s a chart of the SEK real trade-weighted index compared to GBP and CHF. Why should the SEK be this weak? It won’t last.


Source: BIS


Debate brings US election into focus

tvc_47732667c8ca4df6beb95e6e9e08b4b7The first debate between Trump and Clinton tonight should mark the start of a period in which the US election is the dominant theme in the markets. As far as FX is concerned, USD/MXN looks to be the best barometer of political sentiment. As Trump’s popularity rises, so does USD/MXN, and it has continued to make new highs in recent weeks. Of course, the trend rise in USD/MXN started some time ago, with the decline in the oil price and the general strength of the USD the prime drivers, so Trump isn’t the only cause. However, these other factors have been less notable this year, with the USD and the oil price both broadly stable, so the Trump factor is probably currently the major driver.

Having said that, we also have an informal OPEC meeting starting today in Algeria, so the oil price could once again become a factor this week. Expectations for a deal are, however, not particularly elevated, despite this morning’s statement from the Algerian oil minister saying that all options were open at the meeting and “we are not coming out of the meeting empty handed”. Few believe that Saudi and Iran can agree a production freeze (or cut) at this stage, so the risks of a sharp move may be to the upside, though the most likely move may be that the price drifts lower on disappointing news.

However, USD/MXN will be focusing primarily on the Trump/Clinton debate. A perceived Trump victory in the debate will no doubt force it higher again in the short term, but current USD/MXN levels look too high from a medium term perspective. The sharp decline in the MXN in the last two years will continue to benefit the trade balance going forward, and whatever Trump says, the consequences of a Trump victory are unlikely to be dramatically negative for the Mexican economy. Mexican growth is comparatively solid, and the current account deficit manageable. The MXN trend is still down, and should not be opposed in the absence of clear MXN positive news, but there is more potential on the MXN upside medium term.

For the majors, the significance of US politics and the oil price are less clear. Many see a Trump victory as more likely to lead to higher US rates and a higher USD, in part because it would be expected to bring an easier fiscal policy and consequently higher bond yields, but the Fed seems unlikely to react quickly so I wouldn’t place too much weight on this idea. Nevertheless, decent US numbers from now on seem likely to solidify the market expectation of a December Fed hike (currently seen as near a 60% chance) and with the T-note/bund spread at recent highs of 170bps, it’s hard to make a strong case for EUR strength, even though the Eurozone economy has remained comparatively resilient this year (and may even grow faster than the US). This morning’s strong IFO survey should also be EUR supportive. For now though, EUR/USD looks stuck near 1.12, and until we get something more clear-cut on the Fed outlook, seems likely to stay in the 1.11-1.13 range.

There is more scope for action in USD/JPY and GBP/USD. The JPY’s recent strength has been based on the combination of a lack of further BoJ action, the slightly dovish interpretation of the last Fed meeting, and some jitters about equity market levels. Personally, I think these are all very bad reasons to like the JPY. The BoJ continues to run the most aggressive QE program around, the Fed was as hawkish as it could reasonably be given recent data, and while the US equity market may start to look expensive if US rates go up, most other developed markets still look extremely good value given low bond yields. If US rates do go up and push equities lower, The JPY may gain on the crosses, but not against the USD. Having said this, I can’t currently justify opposing JPY strength given the market mood and the upcoming presidential debate. Technically, it looks like we may well be heading for 95.

GBP weakness at the end of last week was supposedly on “renewed Brexit concerns”, though it’s hard to point to a single reason why these should suddenly re-emerge, and this explanation has become a catch-all for journalists when the rationale for GBP weakness is unclear. I remain long term bearish on GBP, especially against the EUR, where fair value in the long run is nearer 0.95 than 0.85, but I don’t see the current rationale for a break above the 0.8726 August high. That doesn’t mean it can’t happen, but levels above 0.87 look a little too extended near term and should offer a short term selling opportunity in the absence of news.

Merkel must spend more



I seem to have left my purse at home

Yesterday’s ECB press conference was, for the most part, fairly lacklustre. No unexpected measures, Draghi sounding quite bored, forecasts very little changed. Markets had vaguely hoped for at least the promise of more action, but got nothing new. But towards the end there were some interesting comments which, together with the G20 statement last week, underline that the ECB and other central banks are telling governments  – specifically Germany – that there isn’t much more monetary policy can do and it is time for some fiscal action. Draghi’s two comments on this were to state that governments which had scope to do more on fiscal policy should, and he noted that Germany had scope to do more. He also agreed strongly with a questioner who noted the weakness of German wage growth and underlined that higher wage growth in Germany was very much desired. In other words, he told Germany they should be spending more money.

There are a few things the German government can do directly about wage growth. The can pay government employees more, and they can raise the minimum wage, but the majority of wage deals are struck without direct government involvement. As Draghi also noted in answer to another question, Europe is not a planned economy. But without stronger German wage growth, it is very hard to get inflation up in Europe, as German wage costs provide an effective ceiling in many industries to wage costs in the rest of Europe. It was precisely because wage costs elsewhere in the Eurozone rose so much faster than in Germany in the 2000s that the rest of Europe became so uncompetitive, and a lot of this was because German wages barely rose at all. Nominal wage costs in Germany rose less than 1% from 2000 to 2008. That’s in total, not per year.  Given the relative weakness of the rest of the Eurozone, unless Germany can get inflation above the 1.5-2% target, there is no chance that the European average can get up there, and to do that, wage costs have to rise a lot faster. So Draghi is putting pressure on Germany to inflate.

There is plenty the German government can do. German is running a (marginal) budget surplus. The government can borrow at negative rates. It is hard to see the downside to expanding borrowing aggressively and spending on infrastructure, especially since they need to find jobs to give all the extra refugees they are letting in (or wage growth will fall further). It would even provide the ECB with more debt for their QE program. It would not just be a good thing for the Eurozone, it would be a good thing for Germany, where I’m told the roads are in dire need of  attention.

Another way of looking at this is to note that the German current account surplus last year was 8.5% of GDP, and is forecast to be over 9% this year. 9%!!!!!! The UK is worried about it’s deficit of 6% (and rightly so) but the UK problem is at least partly the lack of demand from the Eurozone, and the rest of the Eurozone also struggles because Germany doesn’t import enough. Germany is the main guilty party. It needs to reduce it’s current account surplus by expanding demand. There is no way of doing this by monetary policy any more, as rates are as low as possible already. The government needs to take responsibility by increasing investment.

Why Germany hasn’t gone down this route already is a mystery to me. It seems to have something to do with the fiscal conservatives who believe in balancing your budget without regard to the cycle, the needs of the EU as a whole, or anything that has been written on economics since the 19th century. But it really is time to get real, and Draghi and the G20 are ramping up the pressure on Merkel, Schaeuble and co.  It used to be that Japan was the main guilty party for running massive trade surpluses, then China. Now it’s Germany, and action is overdue.


Source: OECD

From an FX perspective, such actions would be supportive for the EUR in the short term, and some may not like that, but amassing a massive current account surplus is far more damaging in the long term, as it will either prevent a European recovery or cause the EUR will surge higher in the next US downturn as capital outflows dry up.





Carney, Prince of pessimism


“There is nothing either good or bad, but thinking makes it so”. Hamlet

The most striking thing to me about yesterday’s raft of information and decisions from the Bank of England was the willingness to act on the basis of forecasts of significant near term economic weakness based on, let’s face it, remarkably little solid evidence. This has continued the trend of the Bank supporting the view that the Brexit vote is a disaster and will lead to a major economic slowdown, a view that is becoming self-perpetuating.

Now, of course, the Bank of England has to try to act on the basis of forecasts, and if it merely responds to coincident or lagging indicators of the economy it risks being seen to be “behind the curve” or setting policy “looking in the rear view mirror”. But we are in a unique situation here. No-one has ever left the EU before. We don’t know what the UK trade arrangements will be in the future, and these will in any case not be in place for more than another two years. The Bank takes the view that the ultimate result will be some reduction in UK supply capacity in 2019 and beyond, though it admits the extent of this effect is very uncertain. Fair enough. But the measures announced yesterday were not really intended to deal with this, but with the short-term demand reaction. It is here that I think the Bank is on very shaky ground, for several reasons.

First of all, we should need no reminding that the Bank’s record of forecasting under Carney has been woeful, from the initial unexpectedly sharp decline in unemployment which quickly left his conditions for raising rates looking ridiculous, to the more recent indications that rates were likely to go up rather than down. Carney’s reputation as an “unreliable boyfriend” is therefore to some extent justified, though I would argue his fault is not so much a lack of foresight – as all forecasters know, being wrong is the norm – as suggesting he has more confidence in his foresight and consequently his understanding of the correct policy path than he had any real right to. Of course, there are uncertainty bands around all the Bank of England Inflation report forecasts, but Carney has always tried to provide an impression of greater commitment to a view than these suggest, in contrast to his predecessor Lord King, who increasingly emphasised that neither he nor anyone else knew the answers to many of the questions he was asked.

So it would be foolish to take the Bank’s forecasts as gospel, even in normal times, and one of the main points made by the Bank yesterday was that these were more uncertain times than usual and that there had been “sharp rises in indicators of uncertainty in recent months”. Once again, fair enough, But the Bank goes on to conclude that such uncertainty could lead to a reduction in spending, particularly major spending commitments. Well, maybe, but maybe not. The impact of uncertainty is very – er – uncertain. Uncertainty squared, if you like.

Of course, as former MPC member Charles Goodhart has noted, we always think the situation is uncertain, and this is not an excuse for doing nothing. That only leads to vacillation. The Bank has taken a view that further monetary accommodation is needed because the risks are on the downside. Again, as Goodhart has pointed out, the impact of these measures is unlikely to be very large, as monetary policy has close to run out of bullets, but they are unlikely to do any harm, at least directly.

So my problem is not with the measures per se, or even the broad slant of the analysis, but with the presentation.  The Bank accepts that there is a lot of uncertainty, and worries that this will lead to less spending. But the reaction of people and businesses is not set in stone. It is about confidence and sentiment. The Bank’s policy reaction is not so much about the actual shape of the trade relations in years to come, but the reaction of firms and consumers to worrying about it. The best way of dealing with this is not to say – “yes, things are pretty awful, so here are some measures that might be a bit of a help if things turn out to be as bad as we fear”. It is to take as positive approach as possible, say that we don’t really know what is going to happen down the road, but there is no real need to change our behaviour now as the picture in two or three years time is really entirely unknown. Brexit may not even be the most important thing that happens over that period. For instance, if the Eurozone’s nascent recovery continues, helped by some expansionary fiscal policy, it may swamp any negative Brexit impact (if there is any).

Now, there is of course some need for transparency, and Carney has taken the view that it was the responsibility of the Bank to put out its best guess of the impact of Brexit ahead of the vote. But I feel this was the first error that has been compounded by subsequent acts. You don’t have to believe, like some on the Treasury Select Committee, that there was a sinister political motive behind the Bank’s negative forecasts ahead of the vote, to think that a more humble view would have been far less damaging. If the Bank had merely said that the impact was uncertain and it would react when there was some greater clarity, the idea that a big slowdown was inevitable would not have become so ingrained, and firms and consumers would be less inclined to believe they should put off big spending projects. The latest Bank action might still have been the same, but could have been presented as an insurance policy rather than a reaction to an inevitable sharp downturn. Now we are in danger of talking ourselves into a downturn, and producing a fiscal expansion we can ill afford to offset it.

Perhaps Carney should have spent more time reading Shakespeare rather than learning about DSGE models. Then he would know that “there is nothing good or bad but thinking makes it so”.

Helicopter time?

While they refused the chance to alter policy in July the Bank of England have indicated a high probability of some easing in August. Why wait three weeks? Some suggest it is to see what the data says, but in practice there will be no really reliable data between the meetings relating to the post vote economy. We have had a weak July PMI reading from Markit, but this is a sentiment survey and it’s hard to gauge whether this weakness will translate into real reductions in spending. The reason for delay can only be to have more time to design the appropriate response, to be able to present the rationale more effectively in the Quarterly Inflation Report, and to consult with the new government to see what the fiscal policy intentions are.

Why is an easing needed? The EU vote is seen as a shock that will reduce growth mainly via weaker investment, though it is possible consumption and exports could also weaken as a result of the hit to confidence. Any policy adjustment should therefore be designed to encourage growth and investment. What are the options?

1 – A rate cut

This seems unlikely to be particularly effective. Companies that need to borrow (generally SMEs) are not restricted by the cost but by the availability of borrowing. Very few companies would borrow more if rates were cut.

The main impact of a rate cut may therefore be via pound. But despite the potential long term advantage of a lower pound for exporters, very little would be gained by driving the pound lower still in the short term. Indeed, a lower pound would probably be bad for growth near term because a lower pound would mean higher prices, lower real incomes and lower consumption. While the lower level of the pound should eventually prove supportive for exports, there is unlikely to be any quick impact when the UK trading arrangements are so up in the air.

2 – More QE

This may be helpful in supporting asset prices, as Bank of England buying of gilts will lead to higher cash balances for the sellers of gilts.But if there is a reduction in expectations of growth the demand for equities and other risky assets will be lower at any given level of gilt yields. So unless the Bank manage to force yields significantly lower with QE, which may be difficult from a very low starting point with inflation rising on the back of a lower pound , the extra cash may just stay as that – cash – much as it has tended to in Japan, and to some extent in past QE episodes in the UK, though this time there is less danger of the extra liquidity being soaked up by bank bond issuance with the banks better capitalised.


3 – Helicopter money

As I have written before (“we already have helicopter money, 09/05/2016”), helicopter money is not new or radical, we have already had it when the Bank used QE and the government allowed the deficit to balloon in 2009. In that year,  the Bank of England bought £190bn of government debt, while net debt rose by £178bn and the deficit rose £79bn from the previous year. You can argue that was about automatic stabilisers rather than a change in policy, so wasn’t a structural fiscal easing, but it was nevertheless a fiscal expansion financed by the central bank.

Of course, some argue more is required for this to be a truly money financed operation. If the government issues gilts to finance fiscal easing, and the Bank buys them in the secondary market, some don’t see this as direct financing, but it’s hard to distinguish the real effective difference between secondary and primary market buying. Of course, the gilts remain on the Bank’s and the government’s balance sheet, and could in theory be sold back to the market, but in reality this makes little difference in terms of current policy, so to renew QE at the same time as the government ease fiscal policy would not be that radical a decision.

Is this the best approach here? Well, the Bank doesn’t have control of fiscal policy, so it’s not a policy they can enact. They can provide the QE, but the government needs to make use of it by increased fiscal spending. This would be effective in stimulating demand in the short run, but the danger is that such monetary financed easing is perceived as inflationary in the longer run. However, I doubt this will be an immediate problem. Other questions about the sustainability of the UK government finances could also be raised, but I would argue this is likely to be seen as less of an issue if new debt is being bought by the Bank of England. It is nevertheless a risky strategy.

4 – Other confidence building measures

The main risk to the UK is a loss of confidence by firms who were planning to invest or foreigners planning to buy UK assets. There is little monetary policy can do about the fundamental issues, which depend on the government negotiating sensibly with Europe. Probably the most important thing the Bank can do is provide optimistic forecasts for the economy, which they can do without contradicting previous forecasts if they implement some easing measures (even though the impact of those measures will depend largely on confidence effects).

What will they do? It’s certainly not clear, and I would not see a rate cut as a foregone conclusion. The decision not to cut in the past had some valid reasons related to bank profitability, and although some of these have been addressed by reducing the banks’ capital buffer, there are certainly some who argue that a rate cut might do more harm than good by putting pressure on banks’ margins. The probable impact of a higher pound from no rate cut may not be a bad thing from these levels, preventing excessive GBP declines. (It is unlikely the pound will recover a long way). So more QE, with the decision on helicopter money effectively left up to the government may be the order of the day.

Short term risk recovery


“It’s dark, and we’re wearing sunglasses”. The Blues Brothers

So we’re in a bit of limbo Brexit-wise. We don’t know when it will happen (some say even if it will happen), what trade deals will be done, who will be allowed to stay in the UK when we leave, how the elections elsewhere will go, and so on. Still, it is reasonable to say it will have some negative impact on the economy on the short-term. Increased uncertainty will reduce investment by at least a few firms, though it may only be delayed if we finish up with a comparatively benign outcome. I am less sure there will be any direct impact on consumer spending, but the decline in GBP will raise prices and reduce real incomes and spending as a result. Conversely, the impact of a weaker pound on exports may be positive eventually, but not in the short run and perhaps never. While UK exports will be cheaper, it takes time for new orders to be found, and the pound still isn’t cheap enough for the UK to compete in most areas. Plus exports to the EU may suffer because of the lack of any detail on the future relationship. All this is broadly known and in the price, but the extent of the economic impact is very uncertain.

We won’t get any post referendum data until August, and it may be that it is hard to see a clear impact for a few months even if there is a slowdown. So we’re driving if not blind, then at least in the dark with sunglasses on (like the Blues Brothers).

The Bank of England needs to decide this week whether these conditions justify some new action. They have already eased capital requirements on the banks but many think this is just a preamble to a rate cut, as bank profitability will now be partially protected. Carney has said he believes some monetary easing is justified. Many think a rate cut will be delayed until August, but we will know very little more in August than we do now. So I expect the Bank will cut rates this week, though other measures are also possible. It probably doesn’t matter too much exactly what the measures are, as in reality the issue is building confidence rather than adjusting the cost of borrowing.

What will be the impact on the FX markets? If there is no action risk will suffer and with it the pound as well as the other “risky” currencies. If there is a cut an initial dip in the pound may well prove a buying opportunity as risk recovers. The Bank knows that something is expected and is unlikely to take the risk of doing nothing because of the probable negative impact on markets of what would be perceived as dithering. Carney has effectively forced the hand of the rest of the Monetary Policy Committee by saying action is necessary. So look for a bold Bank and a risk positive reaction, especially since the global background is better after the better US employment numbers and the withdrawal of the ludicrous Leadsom as candidate for PM. EUR/JPY (or probably better still, SEK/JPY) seem the cheapest major currency pairs to me. Of course, it may not last if the economic impact of the Brexit vote turns out to be very negative, or if the negotiations between the UK and Juncker and co. break up in acrimony. But for now, while the outcomes are unclear, expect a risk recovery as the Bank tries to build confidence.

Over to you Angela


After the vote for Brexit, everyone will be talking about what happens next, what trade deals the UK can cobble together, how we deal with the collapse in the pound. But these economic problems are all soluble. Some of them aren’t even problems. The devaluation of the pound is 100% welcome. OK, it might have been better if it had happened slower, but the pound has been overvalued for years, and the drop only takes it back to something close to fair against the USD. It remains quite expensive against the EUR (see previous blogs). I wanted to sell GBP whether we voted in or out.

Trade deals are a bigger issue, primarily in the area of financial services. However, my belief is that in the end it won’t be in most people’s interests to change things too much. The passporting issues with Europe may make some things difficult for international banks headquartered in London, but won’t change the fact that the talent and the infrastructure are in London. In practice business will be done in the places with the greater comparative advantage. London may suffer a bit, but I sincerely doubt that Paris and Frankfurt will be taking over.

The economic issues may create some short-term pain, but regardless of the various studies out there from supposedly independent institutions, we simply don’t know the long-term impact, mainly because it depends hugely on politics. It is the political fallout from this that will be the key longer term determinant of the impact both on the UK, Europe, and the world as a whole.

In the UK, Cameron is going anyway at the end of this parliament. He may well have to go earlier. It seems likely that he will be replaced by a right-winger, though the Tory Party may try to find someone to bridge the rifts. Theresa May could be the closest thing they have. But it is far from clear that the Conservatives will win the next election.  They are likely to suffer losses to UKIP, and Labour may do better than many think, though in the end Corbyn still seems likely to be a liability.

But more important is what happens in Europe. Will Brexit prove to be a trigger for similar votes in the Netherlands, Denmark, even Italy?  This seems to me to be the crucial question. The EU is not loved in many countries at the moment, and their reaction to the UK vote may now determine whether the bloc survives in its current form. If they follow through on the threats to make things difficult for the UK, it may discourage others from exiting, but it could also backfire. The votes who want to leave are a little bloody-minded by nature. Attempts to assert central control from the EU make anti-EU movements more rather than less powerful. It could also crucially damage confidence. The markets and business now desperately need reassurance. They don’t want to see increasing difficulties in doing business.

From an FX perspective, I would expect the initial response of GBP to broadly stick. The big question is now what happens to the EUR. A moderate response from the EU which attempts to build bridges with the UK would be positive for world markets and for risk. Attempts to punish the UK will be negative for risk assets and negative for the EUR. The EUR is already a cheap currency at these levels, but the economy is fragile and the EUR can get cheaper if leaders mishandle the situation and fail to support confidence.

So it’s over to you Angela and Francois. Accept a new European landscape with grace and forgo all thoughts of punishment and protection and this need not end badly. Try to tighten the reins on the rest of Europe and strike fear into potential exiters and it will finish the worse for everyone.

GBP a sell on the news

Coming into the final week ahead of the Brexit vote, GBP has been given a fillip by the weekend polls, which showed a recovery in the “Remain” vote even in polls done before the tragic murder of MP Jo Cox. The latest Survation poll showed Remain 3 points ahead, while the others over the weekend broadly showed the camps neck and neck. GBP has rallied sharply on the news, and will probably gain some more, if, as I expect, Remain continues to gain ground into the vote. In the end, in spite of concerns about lack of sovereignty and a (largely justified) deep mistrust of the EU and its institutions, the fear of the unknown and the warnings of the economic consequences of Brexit are likely to hold sway. It’s not a certainty, but I would be wary of betting against Remain ahead of the vote.

But after the vote is a different story. As I have noted before, while there is a perceived risk premium in GBP, the pound isn’t cheap even with this risk premium. On the contrary, it continues to trade well above PPP against the USD. While PPP is not a great guide to the appropriate level of the exchange rate in many currencies, at least not in the short run, performance relative to PPP is nevertheless a good starting benchmark, especially in developed markets. In the long run, currencies do move with prices – i.e. it is the real level of the currency that matters – and in recent years relatively high inflation in the UK means the appropriate value of GBP is lower than it used to be. The chart shows GBP/USD relative to PPP over the last 20 years, and it is notable that PPP has dropped from 1.60 to 1.30 in the last 10 years. GBP/USD is currently around 15 figures above PPP, compared to an average of 11 figures in the last 20 years. That doesn’t look hugely out of line, but you have to take into account the fact that the US itself is very strong against most major currencies by historic standards. Add to that the fact that the US still looks much the more likely to be raising rates this year, has smaller budget and current account deficits (as a % of GDP), and terms of trade have moved in the USD’s favour with the decline in the oil price (even though GBP is less of a petrocurrency than it once was) and the case for GBP trading above 1.40 seems hard to make longer term, whatever the referendum result.

But it is EUR/GBP where the story is more dramatic. The chart below shows that EUR/GBP PPP has gone form 0.75 10 years ago to around 0.95 now. GBP was further above PPP in 2015 than it has been at any time in the history of the EUR. Now, many will feel that the problems of the Eurozone justify a big premium in GBP. Fair enough up to a point. But the UK’s outperformance of the Eurozone since the crisis has been built on a bigger budget deficit and a record current account deficit. A weak Eurozone will make it difficult for the UK to grow. And if the UK votes to Remain the problems of the Eurozone will remain the UK’s problems just as they are now. Paradoxically, it would be easier to argue for a big premium for GBP if the UK voted “Leave”. At least then there would be some case for arguing that he UK could disengage from a sclerotic Europe (although in practice that will always be difficult). If the UK votes to remain, greater rather than less integration argues for less rather than more divergence. In fact, Q1 saw Eurozone growth outpace the UK. I doubt this will continue in Q2, but the relative performances are nevertheless likely to be less divergent going forward.

So while the short term focus on the polls and the vote itself dominate and GBP is likely to gain a little more ground into and out of the poll on a “Remain” vote, I would see such an outcome as a big long term selling opportunity for GBP against the EUR after the initial knee jerk GBP gain to 0.75 or so. A normalisation of EUR/GBP would become all the more likely, especially since the UK will likely suffer some political instability as Conservative party infighting continues after the vote. EUR/USD and particularly EUR/JPY are also likely to gain, as the EUR has suffered from concerns about the impact a “Leave” vote might have on Eurozone stability, and global risk appetite has also been damaged and is likely to recover, at least initially.

If there is a vote to Leave these pairs will move in the opposite direction, and the impact on the EUR may be nearly as bad as the impact on GBP. Certainly I would expect both to fall against the USD and JPY.

In summary, GBP is a sell on the news, against the EUR on a Remain vote, after the initial GBP rally,  and against the USD on a Leave vote. But EUR/GBP volatility looks too high in the short to medium term, as the fates of the EUR and GBP are likely to be similar whatever the outcome. There may consequently be better value for option players in buying EUR/USD or EUR/JPY options rather than GBP.






GBP entering Wile E Coyote territory



The GBP focus has been almost entirely on the EU referendum in recent weeks, and this has meant that the steady movement of the polls in favour of the “Remain” camp” has pushed GBP steadily – or sometimes rapidly – higher, helped by still generally short positioning. It will be hard for the market to take notice of anything other than the EU referendum until the vote on June 23, but it does seem as if the focus on this one issue has pushed GBP to levels that look out of line with fundamentals.

The simple metric of the spread between GBP and USD yields worked well until a few weeks ago as a guide to the appropriate level of GBP. But as the US data have improved slightly, global risk appetite has also recovered a touch, and the Fed have indicated that a June rate hike is very possible, US yields have risen and the spread has moved in favour of the USD. At the same time, the UK MPC now seems less convinced that the next move in rates will be up, as the evidence mounts of a slowdown in the economy, which may or may not be related to the referendum. However, GBP/USD hasn’t reacted as usual as short positioning has been unwound in response to the polls, but now there looks to be a gap between the usual yield spread relationship and the currency.


Of course, currency deviations from yield spread correlations are hardly unusual, and can often persist, but usually when there are good structural reasons. For instance, the recovery in the EUR this year has flouted the usual yield spread relationships, but the big Eurozone current account surplus and the low EUR valuation provide some justification for this. There is less case for this with GBP which is still not cheap at current levels and has no current account support – quite the opposite.

For now, it is still hard to see a major turn lower in GBP, as the focus on the polls is still complete and confidence in a “Remain” victory is still increasing. Even so, the 80% probability of a “Remain” victory now priced in will be hard to exceed by much ahead of the polls, and there is still a danger of a swing towards “Leave”. There is now purdah on civil service support for the government “Remain” campaign, so we won’t be seeing any more government produced statistics in favour of the “Remain” case. It looks as if the polls are at best a balanced risk for GBP.

This suggests to me that GBP is vulnerable here. Even if we get a “Remain” victory the fundamentals don’t suggest any case for GBP strength. Yield spreads as shown above are in the USD’s favour, and although this is not the case with EUR/GBP, the high GBP valuation and big UK current account deficit limit the scope for GBP gains against the EUR. There is no particular reason for economic optimism based on the UK data. There may of course by a knee jerk positive reaction to a “Remain” vote, but there is unlikely to be any early evidence that a vote for “Remain” has helped the economy, and there may well be political fallout to deal with related to the split in the Conservative Party that has become more obvious as the referendum campaign has gone on. So rather like Wile E Coyote in the picture above, the market should soon realise that there is nothing supporting GBP strength once the good poll news has gone, and a big drop may well result.


We already have helicopter money

There has been a lot of chat about helicopter money potentially being the next new monetary policy measure to be tried after all the others have tried and failed to stimulate the developed economies. I have just watched Professor Willem Buiter telling Bloomberg that it makes sense but won’t happen because of political opposition. But it seems to me we already have it, even though it hasn’t been announced as such.

To explain. Helicopter money as suggested by Buiter and others is, in his words, a fiscal stimulus (whether in the form of adding money to every bank account or in the form of infrastructure spending) financed not be issuance of government debt but by the central bank “printing” money. While this has not officially happened, it seems to me there is no real difference between quantitative easing and helicopter money. While some might argue that there has been no fiscal stimulus directly financed by a central bank, QE is financing fiscal spending.  The fact is the central bank is buying government debt. To argue whether the fiscal spending is “new” or not is sophistry. And whether this happens in the primary or secondary markets is really irrelevant – issuance finishes up with the central bank with the primary dealers effectively acting as passive intermediary.

Now, fiscal policy settings may not have been consciously altered, but to take the UK as an example, the Bank of England started buying assets (gilts) in 2009 when the UK government budget deficit was 10.8% of GDP. How can anyone argue that the Bank was not financing government spending in doing so, and thus creating “helicopter money”. Who knows what the fiscal policy setting would have been had the Bank not enacted QE? Presumably government bond yields would have been higher had they not done so.

Now, some will argue that the difference between QE and helicopter money is that QE is not permanent. The central bank’s holdings of assets are still part of government debt and will (or at least could) be sold back to the market at some point. The fiscal expansion is still treated as an addition to the budget deficit, even if the debt is bought by the central bank. But isn’t this really a fiction? I think it’s much more likely that the central banks’ accumulated assets will never be sold back to the market and will simply be refinanced on any maturity. In any case, this a decision that will be taken at the time of maturity, and I sincerely doubt anyone’s behaviour is assuming the sale of the Bank of England’s (or the Fed’s or the BoJ’s) stock of debt.

So yes, a fiscal expansion financed by the central bank buying government debt is not just a possibility, it is a possibility that has already happened. Whether central banks will be prepared to finance future fiscal expansion is unclear, but independent central banks may choose to do so if they feel it is in keeping with their mandate (usually of inflation targeting) which many think it is. Certainly, some on the ECB would be willing to expand QE to accommodate increased fiscal spending, and several have indicated that an increase in fiscal spending is desirable in some countries. However, the structure of the Eurozone makes it more difficult to enact there than elsewhere, where there are unitary fiscal authorities with single central banks. The Italian government debt level may still be seen as problematic even if a lot of it is owed to the ECB. The same is not true of the UK debt if it is owed to the Bank of England. I suspect the Bank will find a way to grant the UK government quite favourable terms.


The value is in EUR

The short term focus in FX has been on central banks. The lack of BoJ action,  diminishing expectations of action from the Fed, and the ECB approaching the limits of easing have all contributed to a strong JPY and EUR and weaker USD, while today saw the RBA sucked into the anti-deflation battle once again, halting the AUD recovery. The rationale for focusing so much on minor changes in central bank policy seems to me to be very flawed, and the scale of the reactions on the face of it looks excessive. But what appears to be excessive volatility in reaction to minor news may in fact be something else. It may be a reflection of very out of line initial valuations. As the market’s love of the USD and the story of widening yield spreads fades, recent sharp moves may reflect a realisation that valuations may be a long way out of line if the focus is changing. This is important for anyone looking beyond the short term, and even short term traders should be aware that with the long term USD uptrend under threat, the dominant paradigm may be shifting.

The simplest way of looking at value in FX is to consider real trade-weighted indices. These provide a comparison of the real value of currencies over time. I have put together a chart using BIS data rebased to February 1987 – the data of the Louvre accord when the major countries tried to stabilise currencies. This is not necessarily representative of fair value for reasons I will elaborate on later, but is a reasonable place to start. On this basis, the JPY looks the cheapest of the major currencies, and the Swiss franc the most expensive. The USD went from cheap in 2013 to expensive by the end of 2014 and extended its valuation though 2015. GBP also looks expensive on this basis, albeit a little less so than it was, while the EUR is on the cheap side.


But valuation on this basis misses out two key factors. First, the possibility of structural change and second the cyclical movements in currencies that result from movements in yield spreads. Of course, the latter is by its nature a temporary phenomenon, and cyclical movements in currencies always looks excessively volatile based on yield spreads. The increased attraction of higher yields makes a currency more attractive, but currency moves typically substantially overcompensate for the increased expected return. This is why a change in market sentiment can conversely produce an apparently excessive reaction in the opposite direction, as in the recent move in the JPY.

However, structural changes can and should have a sustained impact on currency valuations. I tend to look at this in terms of movements in the current account. Currencies with big current account surpluses tend to be more highly valued than those with a deficit, as a current account surplus represents a persistent flow into the currency which needs to be offset by capital flows in the opposite direction, encouraged by a higher currency. Changes in the terms of trade are one major factor that can change the structural current account position, but other factors can also have an impact.

In the current situation, the most notable current account changes in recent years have been the rise in the Eurozone current account surplus, the rise in the UK deficit, and the decline, and more recently recovery, in the Japanese surplus. These are important changes, because the history of the real exchange rate index has to be coloured by such structural changes. So the weakness in the JPY we have seen until recently was in part justified by the deterioration in the Japanese current account position. However, the recent improvement suggests some scope for the JPY to recover, especially since the weakness had in any case overshot somewhat. Meanwhile, the big rise in the Eurozone current account surplus justifies a stronger EUR valuation, and the converse is true for the UK.

Now, movements in the current account are also cyclical, with stronger growth economies typically having bigger deficits, and cyclically improving current account positions are not normally positive for a currency, because they are usually accompanied by independent capital outflows towards higher growth economies, usually because of higher or rising yields. But when the relative growth underperformance stops, the surplus doesn’t quickly disappear, and the surplus may become the dominant factor. This is the situation now in the Eurozone. The EUR not only looks cheap on valuation, it is even cheaper when the recent current account improvement is taken into account, and currently the Eurozone is also actually growing faster than the US or the UK (at least in Q1 2016). So something of a perfect storm for the EUR.

As for the JPY, while it looks the cheapest currency compared to history, it is probably less cheap than the EUR when the recent structural changes are taken into account. This is illustrated in the chart below.



So in the longer term I would see plenty of further upside for the EUR. However, in the short to medium term, the USD and GBP could recover if relatively strong US and UK growth returns and yield spreads resume the widening trend. Nevertheless, while his could happen in the next few quarters, I see little scope for this to continue longer term as cyclically adjusted budget positions in the US, and particularly the UK, need to be reined in. In comparison, the Eurozone has potential to expand budgets being that much further below trend output and full employment.


Time approaching to sell GBP again

Three factors have combined to create a GBP recovery in recent weeks.

  1. Brexit sentiment has moved in favour of “Remain”.
  2. Positioning was extremely short GBP and has been squeezed
  3. Global risk sentiment has improved.

However, going forward, the scope for generalised GBP gains is now severely diminished. It should not be forgotten that he case for GBP weakness was not based entirely, or even primarily, on Brexit, but on the combination of overvaluation, declining growth outperformance, and a severe current account deficit problem. While GBP weakness in Q1 did reduce the overvaluation issue, it didn’t eliminate it, and after the recent recovery GBP still looks overvalued. Sluggish growth and a big current account deficit remain an issue.

Of the three factors that have helped GBP to recover, the improvement in the fortunes of “Remain” may be the most important, but has probably gone as far as it can. The FT poll of polls below illustrates that the recent uptick in the fortunes of Remain isn’t decisive, and the movement in the bookies’ odds to about 75% in favour of Remain looks like an overrreacction. There is a lot of water to flow under the Brexit bridge yet, and the Scottish referendum underlined the risk of a late swing. Even if Remain stays ahead, I don’t see the Bookies’ odds improving much from here, suggesting risks are on the GBP downside.

While the CFTC data don’t, as of last Tuesday, show any real reduction in GBP shorts, GBP/USD was below 1.44 at that point and I suspect there has now been a significant reduction in short positioning, though probably not a complete reduction. Option positioning is obviously still largely extant, but with strikes generally well below here, the tendency now will be for GBP moves down to be much more amplified that GBP moves up.

The improvement in global risk sentiment has helped GBP, and I don’t expect this to reverse, but expect GBP correlation with risk to fade. The recovery in commodity prices and producers may have helped GBP via the heavy weight of commodity companies in FTSE, but any further equity strength seems likely to be more broad based. I continue to see more value in the Eurozone.

Practically, I would look for a dip to round 0.7680 to buy EUR/GBP. For now, with Q1 US GDP likely to be quite weak, I would not favour the USD, at least until that GDP number is out of the way (released tomorrow Thursday 28th). The Atlanta Fed model is currently looking for 0.4% (annualised, so 0.1% in UK money) and the market expects 0.7%. However, anything above 1.48 would represent value to sell GBPUSD.


Risk on after Easter pause – sell CHF


I have not written here for a while, mainly because I have not had a lot new to say. I continue to think that equity markets, particularly European equity markets, are extremely cheap. They continue to behave as if we are still in the midst of a financial or Eurozone crisis, when as far as I can see the data has been no more than mildly softer than expected, and yields remain incredibly low. Equities are extremely good value, and even though nothing very exciting is happening or likely to happen, I expect they will move sharply higher before too long.

In FX, the EUR is relatively chipper, helped, like the JPY and the CHF, by the prevailing gloom and lack of risk appetite rather than any optimism about the Eurozone. Most of the FX volatility has been seen in GBP, which is turbocharged by the big Brexit related options positions. Poor UK current account data and what I see as a big risk of a Brexit panic in the next two months suggests to me that GBP remains one bad poll away from a major tumble, so I see current GBP/USD levels (1.42+) as attractive to sell. Long  EUR/GBP has been the better trade in the last few weeks, but has hit a big Fibonacci retracement level above 0.81, and without clear news is likely to struggle to break through that, especially if global risk appetite improves to be more in line with the global data. While GBP and the UK should not be the biggest beneficiaries of any improvement in global risk appetite given the Brexit risks, GBP does tend to benefit against the EUR, JPY and CHF from any improvement in risk sentiment. So in the absence of Brexit news GBP may prove more vulnerable against more risk positive currencies, if, as I suspect, the market starts to realise that they are priced for something much more dramatically bad than the rather dull and sluggish growth story we currently have. But too many people are probably now focusing on GBP to make their year. It may happen, but the big option exposure and reliance on news means timing could be everything.

Thematically, I prefer selling the other heavily overvalued major currency – the CHF. In the recent low risk appetite conditions the CHF has benefitted from its still large current account surplus, but there is nothing good to say about domestic growth, inflation is very negative and the currency remains dramatically overvalued (see real effective exchange rate chart above). In spite of that, The SNB has probably been intervening modestly to help prevent the CHF rising, because in line with the general gloom, Swiss investors continue to refuse to invest abroad so that their current account flows continue to pressure the CHF higher. What domestic investors find attractive in Swiss rates or the Swiss economy I don’t know, and I can’t see it lasting. As long as the Eurozone continues to grow, albeit sluggishly, the EUR represents vastly better value than the CHF. Long EUR/CHF consequently makes sense to me, as does long USD/CHF, though the USD is unloved at the moment and a little expensive too from a big picture perspective. Still, despite all the millions of words written about the US economy and the Fed, not a lot has really changed, with growth a bit sluggish but still OK, employment still growing strongly and inflation on target. If this state of affairs remains the Fed will hike again once or twice this year, and that should be enough to revive appetite for the USD. USD/CHF has important support at 0.9475, and I would stay long while it is above there.

Draghi and the EUR


While there was a whole lot of volatility around the ECB meeting, can we really say that the policies or the statements from Draghi were surprising? The thing that moved the markets hardest was Draghi’s admission that there were no plans to take further action, and there was a limit to how far the ECB were prepared to cut rates into negative territory. But it is bizarre that the markets should think that the ECB, having announced a wide ranging package of aggressive stimulus measures, largely unconventional, should already be contemplating more. To do so would be to admit that failure is likely, which they are hardly going to do (even if the market probably thinks it is). That there is a downside limit to the usefulness of negative rates is also hardly news. Without tiering – which would mitigate the effect of more negative rates on banks and allow them to avoid passing negative rates on to retail customers for longer – the ability of the public to hold cash in preference to a negative yielding bank account provides an obvious downside limit for rates.

So what are we to make of the huge EUR/USD rally? One view is that it provides a massive opportunity for EUR bears. The T-note/bund spread that has been the best guide to EUR/USD over the last year or so has risen further and at 170bps suggests scope to move back down to around 1.0750 (see chart). However, after another bruising encounter with the ECB, the USD bulls may be starting to lose some confidence, so I doubt we will see a rapid move back down to test 1.08, at least until we see some more compelling evidence that the US economy is flourishing and the Fed are set to hike again in June.

However, there may also be some concern that the underlying drivers of EUR/USD may be starting to change a little. The massive Eurozone current account surplus has, for much of the last year, been overwhelmed by the capital outflow from the Eurozone. But even though yields in the Eurozone are unattractive, any loss of confidence in the likelihood of further EUR weakness will limit the enthusiasm of Eurozone investors to put money abroad, especially when there isn’t a huge amount of confidence in growth elsewhere. The lack of any real enthusiasm from Draghi to force the EUR down (illustrated by the lack of tiering which would have allowed still more negative rates, and the highlighting of the “solemn” G20 agreement) will probably further undermine investors’ belief in future EUR weakness.

Nevertheless, I would favour the EUR drifting lower for now, back toward the 1.10 area which is essentially the middle of the current 1.08-1.12 range (1.05-1.15 on the wide). But there is a feel that a sea change may be in the offing in the FX markets , so I wouldn’t get too committed to EUR shorts here. Big picture, you have to remember that these are cheap levels to buy EUR if the ECB’s policies prove successful.

A simpler trade for the USD bulls here may be to sell GBP/USD. Considerations about the Eurozone’s current account surplus don’t apply to the UK – indeed the opposite is true give the big UK deficit. At current yield spreads there also doesn’t look to be any Brexit premium in GBP/USD – so any poll movement in favour of the leave camp in the coming months (and I’m pretty sure there will be one, even though I suspect that in the end the UK will vote to stay) could cause a sharp GBP decline. Even without it, the uncertainty surrounding to issue seems to limit the upside for GBP now the majority of the short GBP positions have probably been squared. Additionally, the upcoming Budget may see more fiscal tightening that further reduces the chance of any monetary tightening this year. GBP/USD is in any case likely to decline if EUR/USD slips back. And while the risk positive market tone and the strong oil price have helped give GBP some support in recent sessions, the big picture truth is that the oil price is still very low here and there is in any case no real risk premium in GBP to account for the decline in oil. Commodity producers listed on FTSE may attract some capital inflow if commodity prices continue to recover, but I wouldn’t see this as the basis for a sustainable GBP recovery. Finally, it is important to remember that while GBP/USD looks low by recent standards, in real terms 1.44 now is equivalent to about 1.58 in 2008 because of high UK inflation in the intervening period.