Category Archives: EUR

Germany’s trade surplus is down to Germany not the ECB

In a speech in Berlin yesterday, Merkel said the German trade surplus was propelled by two factors over which the government had no influence, namely the euro’s exchange rate and the oil price. Well, there’s some truth in that, but not much. It’s fair to say that a weak euro probably does increase the trade surplus, though the impact of the exchange rate is quite delayed and weak. And a lower oil price does reduce the oil deficit, but there is still a substantial deficit in oil so you can hardly blame this for a trade surplus.  These factors may have led to a higher trade surplus than would otherwise have been the case, but they are not the primary cause of the large and persistent German trade surplus. That much is obvious just by looking at the German trade and current account surpluses in recent years. Yes, the surplus has increased a little in the last few years in response to the lower euro and the lower oil price, and is expected to be 8.8% of GDP in 2017. But the current account surplus was already 6.8% of GDP 10 years ago in 2007 and 7.1% of GDP 5 years ago in 2012. In 2007, the euro was around 10% higher in real effective terms (for Germany) than it is now, and the oil price was around $70 a barrel. In 2012 the euro was actually not very far from current levels in real effective terms (though stronger against the USD), and the oil price averaged around $110 per barrel. The German trade and current account surpluses were nevertheless still very large. Merkel’s attempts to claim that they are a function of a weak euro and a high oil price just won’t wash.

german stuff

Source: OECD

Merkel’s comments are an attempt to evade criticism of German policy, which have come most recently from the US but have been heard before in Europe. She is arguing that the problem is out of her control because she doesn’t want to take the measures necessary to reduce Germany’s trade surplus. What could be done? It is not an easy problem to solve, but she could make some contribution with easier fiscal policy. Her fiscal stance has been very conservative and makes Britain’s attempts at austerity look spendthrift. The German budget is expected to show a 0.5% of GDP surplus in 2017, following similar surpluses in the previous 3 years. This is certainly on the austere side, and government debt has been falling fairly rapidly as a result, expected to hit just 65% of GDP this year, back to 2008 levels after seeing a peak of 81.2% in 2010. Of course, the original target for this debt level was 60% of GDP, but much higher levels are sustainable with much lower real interest rates. The Eurozone average government debt is over 90% of GDP.

german stuff1

Source: BIS

However, the big problem is really the private sector rather than the public sector. The private sector save too much (or don’t invest enough). The proper monetary policy response to this is to keep interest rates as low as possible, so on that basis the ECB are doing exactly the right thing. But more could be done with fiscal policy in Germany, either with stimulative tax cuts, or more government spending. This would both directly encourage imports and, by forcing up wages and prices, would lead to improved lower real interest rates and reduced German competitiveness. Part of the reason for the big German trade surplus is the big wage competitiveness advantage built up in the aftermath of the creation of the euro. That’s why Germany has been running big trade and current account surpluses since the mid 2000s.

But Merkel doesn’t really want to do this. She doesn’t want to undermine Germany’s competitive advantage with the rest of Europe (as well as the rest of the world). She doesn’t want to run a less austere budgetary policy and alienate the conservative wing of the CDU. So she’s blaming the ECB and the oil price. The rest of Europe need to tell her she’s wrong. I see no chance that Draghi or the ECB will take any notice of her, so logically there is little reason for the Euro to benefit directly from her comments.  But with the political and economic winds behind it, there is little reason to oppose euro strength anyway. The CHF and GBP look the most vulnerable of the major currencies in this environment, though the USD could also suffer if rate expectations drop away significantly.

german stuff2

Source: EU Commission

A strange time to worry about the euro

An interesting survey from Central Banking shows central bank reserve managers have apparently lost faith in the euro, with the stability of the Eurozone supposedly this year’s greatest fear. Apparently concerns over political instability, weak growth, and the European Central Bank’s (ECB) negative interest rate policy have led central banks to cut euro exposure, with some eliminating it completely. This strikes me as very strange timing.

Now, there is of course uncertainty about the Eurozone. But it seems odd to me that these reserve managers have chosen this year to start worrying. Where have these guys been for the last 9 years? There has been uncertainty surrounding the Eurozone since the financial crisis (and before). Greece’s woes have hardly been a secret – they have had two debt restructurings in the last 5 years. Yields in the Eurozone periphery blew out to extreme levels when the Greek crisis was at its height, reflecting concerns about Eurozone break-up. Back then, concerns were not confined to Greece either – Spain and Portugal were also very much in the firing line. By comparison, the current bond market spreads show very little evidence of worry about Eurozone break-up. So why are the central bankers in a tizzy all of a sudden?

One of the reasons they give is the negative interest rate policy from the ECB. It is understandable that investors aren’t happy with this, but it is hardly a new phenomenon. The deposit rate went negative in mid-2014. Furthermore, concern on this issue shows a worrying degree of money illusion. Using the OECD’s forecasts for 2018 inflation, the table below shows real interest rates across the G10.

real yieldsSource: FX Economics, OECD, national central banks

On this basis, the real policy rate and real 10 year yield for the Eurozone (using France as a proxy for the 10 year yield) aren’t really that low by international standards. In fact, the real policy rate is higher than in both the UK and US. I have ranted about money illusion many times before, so I won’t bore on, but you would have hoped that international reserve managers were a little bit more savvy than to look just at nominal rates.

So maybe they are worried about politics. I find this ironic. The UK votes for Brexit and the US votes for Trump and reserve managers are worried about politics in the Eurozone? It’s true that the Eurozone is existentially more vulnerable, and therefore you can regard political instability as more dangerous. But in reality the chance of a Le Pen victory in France is tiny, and even if she did win, the chance of France leaving the EUR given she has no parliamentary support is similarly tiny. The bigger danger is Italy, but again, despite the anti-euro lead in the polls, there is unlikely to be an election this year, and forming a coalition that would genuinely be prepared to take Italy out of the EU would be extremely difficult. Of course, Italy leaving would be disastrous (for Italy but also for the EU) so this is not a scenario that can be taken lightly. For this reason it is also extremely unlikely to happen, but that doesn’t mean there wouldn’t be major market concerns if the possibility started to look more real. Nevertheless, it is surprising that yield spreads haven’t blown out much further is this was a genuine concern.

As for weak growth, this has been an endemic problem in Europe, but it is again strange to worry about it now when Eurozone growth is picking up and looks set to record its fastest rate since 2010.

There is no doubt that the EUR has suffered from a lack of foreign capital in the last year. In 2016 there was a reduction in Eurozone portfolio liabilities of EUR66bn – foreigners sold a net EUR66bn of Eurozone assets – compared to net buying of nearly EUR400bn in 2014 and Eur300bn in 2015. As long as this continues – the net portfolio and direct investment outflow more than offsetting the current account surplus – investor concerns about the EUR are likely to be self-fulfilling. But I am not sure how long this attitude can last. The EUR is already very cheap by long term measures, and the economy appears to be picking up. If Le Pen loses – as seems very likely – I suspect it will be hard for the markets to maintain this negative attitude indefinitely. But then I don’t really understand why reserve managers have turned so negative in the first place.

Trade ideas for 2017

sp-vs-eurostoxx50

  1. Long Euro Stoxx 50 – Entry 3280, target 4000, stop 2870.

European equities are just too cheap. The Euro Stoxx 50 has massively underperformed the S&P 500 since the financial crisis. Part of this is of course because the Eurozone economy has underperformed the US. But the scale of US outperformance is excessive. US nominal GDP has risen 24% since 2008. Eurozone GDP has only risen 10%. But the S&P 500 has risen 45% since the 2008 high, while the Euro Stoxx 50 is still 28% below its 2008 high. Of course, part of the strength of the S&P is due to easy monetary policy – US 10 year yields are, even with the recent rise, around 1.5% below where they were pre-crisis. However, this is even more of a case for Euro Stoxx strength. Bund yields are more than 4% below pre-crisis levels, and while peripheral yields have fallen less than bund yields, most have fallen more than the US 10 year.

With Euro Stoxx down 28% from 2008 highs and long-term yields down around 3% or more, the risk premium has increased enormously. Now, many will point to all sorts of risks to justify this. French, German, Dutch and maybe Italian elections next year. Greece still an issue. Brexit.  But if the US can welcome Trump with higher equities, a European political shift to the right won’t necessarily be bad for stocks. European growth appears to be improving slowly, and European yields are set to stay a lot lower than the US. Plus the above calculations don’t take account of the 35% decline in the Euro since 2008. Currency adjusted, the underperformance of  European equities is even more dramatic.

Of course, it may be that higher US yields lead to a US equity decline, so perhaps some of this should be taken relative to the US. But if US yields rise because of stronger growth and inflation under Trumponomics, it will benefit European growth as well, and will probably not mean a drastic decline in US equities, making European equities all the more attractive.

2. Long USD/CHF – Entry 1.03, target 1.20, stop 0.95.

There is also a case for long EUR/CHF but it makes sense to be long USD on the basis that even after the latest change in the Fed outlook the market is still pricing quite a moderate US rate profile through 2017. An aggressive Trump spending programme could lead to still more spread widening in favour of the USD.

Even so, I find it hard to sell EUR/USD looking for moves below parity. It does look likely to happen, but long-term the EUR will be good value at those levels assuming the Eurozone disaster scenarios don’t play out, so I look for a trade that is better value. The CHF remains the world’s most overvalued currency, and continues benefit from general distrust of the EUR. But if Italian banks don’t go under and growth continues to steadily improve helped by further US fiscal expansion, the case for holding CHF against the EUR looks weak, with the EUR likely to benefit against the CHF from improving equity market confidence (see above). Negative Swiss interest rates will become even more of a disincentive to hold CHF if other assets are becoming more attractive.

In disaster scenarios, the SNB is likely to ensure the CHF benefits less than the USD.

3. Short GBP/SEK – Entry 11. 50, target 9.50,  stop 12.25.

This was to some extent the trade of 2016, but I think it has further to run given that it has had a sharp correction higher since sterling’s “flash crash” on October 7th. The Swedish economy continues to show the strongest growth in Europe, and although the Riksbank remains highly focused on inflation and will consequently not be tightening policy anytime soon, the Riksbank is nevertheless likely to tighten before the ECB and before the Bank of England, as growth in the UK looks likely to be restricted by rising inflation and consequently weak real incomes and consumption.

Brexit is more of a swing factor than a pure negative for GBP, but it seems unlikely that the UK will achieve any real clarity ahead of the major European elections this year, while concerns may build about another Scottish referendum. The risks consequently see to be more on the GBP downside in the short term.

Although the SEK has gained against GBP in 2016, it has been generally weak against other currencies, and despite the UK’s Brexit issues and massive current account deficit, GBP/SEK is only in the middle of its range seen since the financial crisis. Furthermore this doesn’t take into account GBP’s real appreciation due to relatively high UK inflation over the period, which means that in real terms GBP/SEK is nearer the bottom than the top of its post crisis range. Rising UK inflation will be creating more real GBP appreciation going forward, further supporting the case for nominal SEK gains.

 

Disclaimer: These are my ideas and I believe them to be well founded. However, they could easily go wrong. All trades are taken at your own risk. I take no responsibility for losses (and no claim on profits) made due to following these ideas. 

ECB promises are worthless

draghi

There has been much discussion about whether the ECB has tapered or not. They have reduced the size of their monthly purchases but extended them until the end of the 2017 rather than the expected 6 months from March, so that the promised total of asset purchases is actually greater than had been expected (the market was looking for a promised 6 months of EUR80bn = 480bn but they have 9 months of 60bn = 540bn). But this is still a tapering. Why? Because promises are worthless.

The ECB’s “guarantee” that purchases will be at least 60bn a month for at least 9 months is no such thing. Of course, they are very likely to stick to the letter of this promise, but if circumstances changed so that a tightening of monetary policy was necessary, would they really choose not to enact one? How irresponsible would that be? If they did fail to respond to the need to tighten the markets would react anyway. Anticipation of higher inflation would lead to substantially higher bond yields regardless of whether the ECB chose to continue with a policy that is clearly misguided.

There is a clear logical problem with the ECB (or any other central bank) making promises about future policy while at the same time pledging to stick to its remit of hitting its inflation (or any other) target. While in practice it is unlikely to have a problem sticking to its promises, that is because the promises are well within the range of policy options that they would design to hit their targets under normal circumstances. Had the ECB chosen to go with 80bn a month for 6 months, the odds are they would have extended this again beyond 6 months, probably with smaller volume, since even Draghi has admitted that they are unlikely to stop their asset purchases dead, but  rather taper off. But unexpected things can happen, and if they do the ECB may be forced to renege on their promises. If a tightening in policy is necessary, they might choose a different method and thus stick to the letter of their promise, but the promise itself is still valueless if there are circumstances in which the ECB would renege, whether in spirit or in letter.

The market has chosen to accept Draghi’s protests and not see the taper as a taper. But it is a taper. Future policy promises are worth nothing because central banks will do what they perceive is right at the time, and will effectively override any policies they have committed to if circumstances demand. It is time the markets stopped taking notice of this nonsensical approach of promises. Forward guidance is one thing – providing an idea of what they expect to do – though events have shown even this is wrong often enough to have very limited value. Promises are a step too far, and imply either omniscience  – so that there can never be a need to renege on a promise – or irresponsibility – with central banks prepared to sacrifice correct policy to stick to a promise they made under different circumstances. Central banks are not omniscient, and should not be irresponsible – so promises of this short are worthless and worse, potentially damaging.

Trump: the new Reagan for the USD?

EUR/USD (equivalent) under Reagan 

eurusd-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.

 

 

EUR weighed down by GBP not Draghi

eurandgbp

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.

Merkel must spend more

 

merkel1

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.

current-accounts

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.