After flirting with the 0.75 area for a few days, EUR/GBP has pushed through on this morning’s weak industrial production data and has potential to start making real ground to the upside. Technically, there are some reasons for caution. Although last week saw a strong weekly close at the highest level for a year, we have had seven consecutive up weeks and the weekly channel top at 0.7525 hasn’t broken convincingly. But, if not now, when?
GBP has been overvalued for a long time, most particularly against the EUR, it’s largest trading partner. It is also a lot more overvalued than it looks, for two reasons. Firstly, because UK inflation has been much higher than inflation in other major economies since the financial crisis. While inflation has recently been subdued, CPI in the UK has risen 10% more than CPI in the US or the Eurozone since 2008. So 0.75 now is equivalent to 0.68 in 2008 in real terms. Secondly, the UK is running a current account deficit of 6% of GDP – the largest in the developed world – while the Eurozone is running a surplus of 3% of GDP. While the UK deficit has come about mainly because of declining UK investment income rather than a rising trade deficit, it won’t be closed by improved export performance at this level of GBP. Historically, current account positions DO matter for valuation over the long run, and the widening of the UK deficit suggests to us that long run fair value for EUR/GBP is more like 0.85 or 0.90 than 0.75.
But this has been the case for some time Why should GBP suffer now?
- The long awaited UK rate hike still seems to be disappearing into the distance as wage growth stalls, so those looking to buy GBP on yield spread grounds have little support in the short run.
- GBP has already fallen a long way against the USD, and while it may fall further, yield spreads between the US and Europe have also stalled or narrowed of late as US data has slightly disappointed since the Fed rate hike, so there seems limited downside for EUR/USD from here in the short run, suggesting at least as much GBP downside potential against the EUR
- The EU referendum question. The possibility of Brexit is clearly negative for GBP and while I personally think there will be a strong majority in favour of staying in the EU, the foreign investment that the UK needs to funds its current account deficit is unlikely to be too enthusiastic while the question is in the air.
- Policy wise, there is nothing the government or the Bank of England would like more than a weaker pound. They will never try to force it, but I wouldn’t be surprised to see a little verbal encouragement of GBP weakness.
- A weak oil price is more supportive for the Eurozone than the UK, given the Eurozone is a much bigger net oil importer.
By the time we get to the referendum (maybe June) I expect we will already have seen the big decline in GBP, and we may see a recovery after the referendum if, as I expect, we get a vote to stay in. The recovery may start before the referendum if it looks like the “remain” campaign is going to win easily. There is no time like the present for the GBP bears to get the ball rolling.
Yes, the Chinese data has been a bit soft, and the US manufacturing numbers haven’t been too special either. Plus we had the North Korean “earthquake” to jangle some nerves. But the European PMI data has been solid enough, and the US employment data continues to impress. The oil price is hitting new lows, but that’s double edged for growth and equities. It’s not all great, but it doesn’t all look terrible either. In my book it’s not bad enough to create a major sell off in equities. Yet we are at the lowest level since October. In the US, this may make some sense. Rates are higher and the recent data has been on the disappointing side. But for some European markets, the price action is harder to justify. Sweden in particular is testing the October lows which were also the 2015 lows, but rates are negative in Sweden, the currency is still very low against the USD, and growth is running close to 4% and expected to hold there for 2016. It’s hard for European markets to buck the trend of the US, but it’s hard to understand them underperforming.
This is also reflected in a bit of an FX puzzle. EUR/JPY has been hammered in the last few sessions, but the EUR doesn’t look the obvious currency to suffer from risk aversion. The European numbers have been reasonable, but in any case, the EUR has tended to benefit from risk aversion in recent months, which makes sense given that it has been the favoured funding currency. AUD, CAD, GBP, USD and NOK all look more obviously vulnerable to risk negative news.
On a fundamental basis, it is also hard to justify EUR/JPY weakness on risk aversion, as the Eurozone is now the biggest current account surplus region, and positioning remains more heavily short EUR. It may be that the ECB does eventually ease more, but at this stage the BoJ is still implementing QE even more aggressively. Valuation wise, I would argue that the EUR is also slightly cheaper than the JPY, and though some will disagree with this assessment, valuation isn’t a major issue. All in all, I can see no real case for major EUR/JPY weakness with the obvious equity correlation looking harder to justify. Yet we are approaching the 2015 low at 126.10. It’s hard to oppose current momentum, but seems to me this should hold until there is clearer evidence of risk aversion extending. So even though the chart looks pretty compelling in favour of the longer term JPY bulls, I’d look for a near term bounce.
The EUR has taken a bit of a hiding in the last few days, but I’m not convinced this makes a lot of sense. Sure, the German CPI data was a little weaker than expected, but Eurozone CPI is in line and basically unchanged on a core basis for some time. Headline will rise on base effects in the coming months. I don’t think there’s a reason to expect imminent further ECB easing on the basis of the data we have had.
The real side of the economy still seems to be holding up reasonably well. Though China and the oil based emerging markets are slowing, and this is clearly going to hold back Eurozone export growth, Europe’s domestic demand continues to be well supported by the real consumption boost provided by the lower oil price. The Eurozone PMI data has been solid while the US numbers have been weak. There is more reason to doubt the prospects for two US rate hikes this year than to start looking for further ECB easing. In a risk negative market I struggle to understand how this translates into USD strength when the data suggests there are still plenty of long USD positions out there.
Nevertheless, you have to respect the price action so I wouldn’t jump in too quickly, but I see levels near 1.07 as good value for EUR/USD.