Category Archives: FX

GBPSEK selling opportunity

The Turkish crisis and Brexit muddle create an opportunity to sell GBP/SEK

 

Turkish crisis dominates the action

This month global markets are mostly concerned with Turkey, with the sharp fall in the currency the main driver of concerns about deteriorating credit quality due to large net external liabilities. The degree to which foreign currency debt of Turkish entities is currency hedged is unclear, but is key for determining their solvency. Other than the weakness of the currency, the economic situation is in any case vulnerable, but has been for some time. But from a baseline of vulnerable, conditions have deteriorated steadily in the last year or two, with inflation rising and the current account deficit widening, in part because the central bank has not been allowed to make the rate rises required to stem these trends. This political aspect of the problem makes it much more intractable, especially when you throw in the pastor and the aggressive tariff response from Trump.

It is hard to see the endgame at this stage. Funding the current account deficit will remain very difficult as long as there is no action. Even significant interest rate rises may not help much at this stage. Capital controls may come in, and there are risks of default on external debt. However, most of the risk is not government debt, as in previous crises, but corporate debt. This makes a bailout unlikely and difficult, but also probably reduces contagion risks. While there is significant exposure to Turkish debt among European banks, it is not game changing – even the most exposed banks would survive the worst case scenario as long as the problems remain isolated to Turkey.

Which leads to the main question, which is one of contagion. Most commentators argue that this is the primary risk, citing parallels with previous EM crises, notably Asia 97. And they are right, because markets are never entirely predictable, and if appetite for risk disappears what currently appears a perfectly solid investment can quickly become vulnerable. (Almost) everyone needs to raise money, and in such circumstances even perfectly solvent entities can struggle to refinance if markets suddenly become unprepared to fund. As Hamlet says “there is nothing good or bad but thinking makes it so”, and shocks like Turkey can lead to some pretty muddled thinking.

Nevertheless, we doubt that the Turkish situation will lead to a big global meltdown in EM, or a renewal of the Eurozone crisis. Even worst case scenarios should remain contained.  While we may have a period of pressure on some EM currencies and higher EM yields, in the end the global economy is starting from a position of reasonable health driven by good US growth and improving Eurozone growth, combined with a generally more solid global banking system. There are savings looking to be deployed towards higher yielding assets in a world of still very low yields. There are no certainties, but this episode looks likely to present an opportunity to buy risky assets. Of course, care is required, as especially in August things can go a lot further than we would expect before turning. Things that look cheap may yet get a lot cheaper, so technical signals that the market has completed its rout need to be awaited.

Opportunities created by Turkish crisis

The obvious opportunities are the emerging markets that have suffered in sympathy with the Turkish Lira. The ZAR, BRL, and even MXN have all weakened, and there may well be value there. But getting these right requires good timing and a clarity that the crisis is over. In these situations it is often better from a risk/reward standpoint to consider the less obvious collateral damage. In the G10 space the two currencies that have suffered the most since early August are the NZD and SEK. The NZD is understandable as it can be considered the closest thing to an emerging market in the G10 space. But the SEK? Sweden has a current account surplus, very low interest rates and inflation, the strongest growth in Europe and a very secure budget and banking system. It is no-one’s idea of an emerging market. Nevertheless, the SEK does tend to exhibit characteristics of a risk positive currency. This is in part a historic issue harking back to the days when Ericsson made up 30% of the value of the Swedish equity market and it was strongly identified with the tech boom and bubble. But nowadays, while still showing one of the strongest growth rates in the EU, there is no particular dependence on tech. Both EUR/SEK and USD/SEK have risen to levels that have to be considered excellent longer term value regardless of which way the Turkish crisis is resolved, but GBP/SEK may represent the best trade, given the risks involved in the run up to the Conservative Party conference and the October EU Summit.

With the UK parliament on holiday, there have been no significant developments in the last couple of weeks, but there has been more and more noise suggesting that the risk of a “no deal” Brexit is increasing. The main upcoming events are the UK Conservative Party conference from September 30 to October 3 and the EU Summit on October 18/19. Neither looks likely to provide any real progress on Brexit, and the prospect of “no deal” will consequently become even more probable, at least as far markets are concerned.

There are several reasons for the lack of progress, but the two main ones are the lack of any majority in the UK parliament for ANY Brexit plan, and the perception on both sides that the threat of “no deal” – and the brinkmanship involved in that – is necessary in order to get the “best” deal for their side. It may be that an apparent increase in the probability of “no deal” is actually a necessary condition for a deal to be done, but the process will nevertheless have continued market impact.

For what it’s worth, we believe that a free trade deal of some sort is the most likely eventual outcome in the Brexit process. Probably the best reason for this is Ireland. “No deal” would require a hard border, and that is anathema to both sides as well as effectively contravening the Good Friday agreement. But even though a free trade deal is likely eventually, that doesn’t matter right now because it isn’t the most likely next step. More stress is required to produce that outcome.

From a trading perspective, the battleground is GBP. We look to play this from the short side not only because the next events look likely to be GBP negative, but because GBP is starting from a position which we regard as barely below fair value. The current price does not adequately reflect the risks of Brexit.

GBP/SEK looks an attractive vehicle to express GBP weakness here.

GBPJPY hitting selling area

Forget about Brexit for the moment. We don’t know what it will look like, when it will happen or what the global story will be when it does happen. Let’s just look at where the currencies and economies are now, and ask if that position makes sense. In the case of GBPJPY, it doesn’t.

The market is being asked to finance an annual  relative current account position between the UK and Japan of more than $300bn in Japan’s favour, but is being offered no real yield advantage to do so, and GBP/JPY is already relatively expensive relative to PPP and to history. So even without worrying about Brexit, it’s pretty hard to make a case for GBPJPY to be at current levels.

GBPJPY is currently trading around 152. Is that high or low? Well, if you just look at a normal chart, you might think it’s low, because GBPJPY has been falling for the past – well – forever. Even in the past 20 years it has round about halved in value. Though it is around 30 figures above its all-time low (see chart below).

gbpjpy

But this is entirely a nominal picture that ignores inflation. Most of the reason for GBP/JPY’s decline in recent years has been the higher inflation in the UK relative to Japan. The easiest way to illustrate this is to look at GBP/JPY relative to GBP/JPY PPP, as shown in the chart below.

 

gbpjpy and ppp

Source: OECD, FX Economics

So although GBP/JPY has been falling steadily, it is now trading above PPP, and is further above PPP than its average over the last 20 years, as shown in the chart below.

gbpjpyppp

Source: OECD, FX Economics

So, in real terms GBPJPY actually looks quite high compared to history.

Is this justified? Looking at the data, the simple answer is no. UK real yields are not relatively attractive. At the 10 year tenor, the nominal spread is 1.2% in favour of the UK. But the inflation differential in 2017 was 2.6%. Even though this is expected to narrow in 2018, it is still expected to be 1.6% according to OECD forecasts. So real yields actually favour Japan and the JPY (even more so at the short end of the curve where nominal spreads are smaller).

What about other determinants of cross border flows? The current account position implies a need for a cross border flow, and the UK was in deficit in 2017 to the tune of about 4.7% of GDP, while Japan was in surplus by 3.9% of GDP. This difference is only expected to narrow very marginally in 2018.

So the market is being asked to finance a relative current account position of more than $300bn, but is being offered no real yield advantage to do so, and the currency is already relatively expensive to PPP and to history. So even without worrying about Brexit, it’s pretty hard to make a case for GBPJPY to be at current levels.

If we add Brexit into the mix, it’s worth noting that GBPJPY is now above the high it traded the week before the Brexit referendum. Whatever you think about Brexit, it is pretty hard to argue that it currently justifies a stronger currency.

So much for valuation. But a large part of this story is about the weakness of the yen rather than the strength of sterling, and the weakness of the yen has historically been well correlated with positive risk appetite, reflecting the historic tendency for the surplus country to be keener to place money abroad at times of positive risk sentiment. But this makes far less sense than it used to when the real yields available outside Japan are no greater than the yields available inside Japan.

So it seems to me that these represent excellent levels to sell GBPJPY for the medium to long term. For the technical minded. 153.80 represents the 76.4% retracement of the move from the 164 May 2016 high to the 123 October 16 low.

USDMXN way out of line with fundamentals

I am far from being an expert on Mexico, but I am aware of the basic story behind the weakness of the MXN in the last few years. General USD strength, concerns about protectionism under Trump and weakness in the oil price have all contributed, while related NAFTA negotiations and the election this year are helping to prevent a major recovery. But the extent of MXN weakness just looks way out of line with the available evidence. Of course, it is possible that trade arrangements with the US become more problematic, but the MXN is around 25% weaker than you would expect relative to “normal” valuation. That is, USD/MXN has typically traded around 70% above PPP in the last 20 years. With PPP currently around 8.90, this suggests the “normal” level would be around 15.15. The current price near 19 just seems to price in all but the very worst bad news, so that the risks from here lie overwhelmingly on the upside for the MXN.

The chart below illustrates just how far away from normal the MXN is. The only time in the last 30 years that we saw the MXN as weak as this was during the “Tequila crisis” of 1994/1995. This was a proper crisis. The current account started off with a deficit of nearly 6% of GDP and the liberalisation of markets led to a devaluation of the peso, a loss of confidence in the economy, a balance of payments crisis, a 6% decline in GDP in 1995 and ultimately a US led bailout. The current situation is comparatively benign. While the current account deficit has increased, it is not in worrying territory, and growth, though a little weaker than desirable, is reasonable. GDP per capita is around 30% higher relative to the US now than it was then. There are of course concerns surrounding the relationship with the US, but markets in general are no longer expecting Trump to carry through his more aggressive threats.

I’m not going to predict the outcomes of NAFTA negotiations, or the Mexican elections. As I say, I’m no expert on these issues. But valuations say that the MXN is substantially undervalued unless we get a replay of the Tequila Crisis, and even the pessimists aren’t forecasting that.

 

usdmxn

Source: OECD

Mexico current account

Source: World Bank, OECD

 

Rate hike won’t sustain GBP strength

I’ll make this short because I’ve covered this ground in this blog before, but recent gains in GBP in response to the latest inflation data and the more hawkish tone from the Bank of England at the September meeting make it worthwhile to go over it once again.

First, the basics. Higher inflation, other things equal, should mean a currency goes down, not up, in order to maintain the relative price level. The fact that currencies tend to rise in the short run with upside surprises in inflation is an anomaly seemingly based on a combination of money illusion and a historic expectation that higher inflation will trigger a response from the central bank that will actually mean higher real interest rates. This seems to be a distant memory of the 1970s and 80s, because it is hard to find occasions in the more recent past where higher inflation has triggered higher real rates (as opposed to just higher nominal rates) in the major economies. Of course, real rates have been falling steadily for years as a result of structural as opposed to cyclical factors, but even the cyclical upturns have seen precious little rise in real rates (see the FX market needs to rethink inflation, November 18 2016).

All this is relevant to the recent reaction to UK news. Inflation is above target and still rising, mainly in response to the decline in GBP seen after the Brexit vote. The MPC is now considering a rate rise in response. But the rate rise will come nowhere near full compensation for the rise in inflation seen since the Brexit vote. Real rates have fallen, and even if we see a 0.25% rise in the base rate soon they will still be well below where they were not just before the Brexit vote, but immediately after the BoE cut in rates after the vote (see chart below). While inflation has also risen elsewhere, it has not moved as much, and UK real rates remain unattractive, and will remain unattractive even if they move modestly higher.

Real UK base rate

uk real rates

Source: Bank of England

On top of this, there is the question of whether higher real rates in these circumstances, if they were to come, should be seen as positive for GBP. In general, higher real rates are theoretically positive for a currency, but in the current UK situation Carney’s speech yesterday makes it clear that his case for higher rates is based primarily on the expected inflationary consequences of Brexit. This is not the usual cyclical impact of rising demand, but a structural change that will reduce both demand and supply and raise prices, at least in the short run, with Brexit effectively acting as a de-globalisation. Carney’s case for higher real rates essentially rests on the belief that the Brexit impact on supply will be greater than the impact on demand. This is debatable (as he himself admits) and it is hard to instinctively see this as positive for GBP, because real rates will be rising because of reduced potential output due to reduced efficiency and lower productivity. Any benefit from higher portfolio inflows to seek out the higher real rates seems likely to be offset by reduced inward direct investment as a result.

In summary, the case for GBP gains based on a more hawkish BoE seems very weak. Any rise in nominal rates looks unlikely to translate into a rise in real rates, and to the extent that real rates are higher than they would have been, it will likely only reflect the Bank’s concern that Brexit is going to undermine potential UK output growth by reducing productivity and undermining existing supply chains. Of course, that doesn’t mean GBP will reverse recent gains quickly (the market can remain irrational longer than you can remain solvent), but looking at the charts suggests to me that 1.38 would be a very good area to sell GBP/USD, while anything below 0.87 looks a buying area for EUR/GBP.

Riksbank policy – dangerous, myopic and unsustainable.

I’ve seen some fairly odd decisions made by various central banks in my 30 odd years in the markets. But they normally have some sort of explanation, even if you don’t agree with it. But in the case of the Riksbank decision last week, I honestly cannot understand the rationale for not only leaving rates and asset purchases unchanged, but also leaving projections for future policy unchanged, with the first rate hike not expected until 2018. It is frankly utterly bizarre, and smacks of an ill-conceived desire to maintain a weak currency – a desire that has no justification whatsoever given Sweden’s macroeconomic circumstances.

Even at the July meeting, it was quite hard to justify the super easy stance of the Riksbank. The economy has been growing at 3% +, the employment rate was at record levels, and inflation was only modestly below target. But despite having the strongest economy in the G10 Sweden was running one of the easiest monetary policies, with the repo rate at -0.5% and asset purchases continuing. At the September meeting the Riksbank had to consider the news that GDP growth had accelerated to 4% y/y in Q2, and inflation had risen to 2.4% on their targeted CPIF measure, above the 2% target for the first time since 2010. But the Riksbank decided not only to continue with their hyper-easy policy, but didn’t change the view that they wouldn’t raise rates until the second half of 2018. Why? Well according to the Riksbank:-

” For inflation to stabilise close to 2 per cent, it is important that economic activity continues to be strong and has an impact on price development. It is also important that the krona exchange rate does not appreciate too quickly.”

In their report the Riksbank accept that growth is stronger than expected, inflation higher than expected (and above target), resource utilisation is approaching historic highs, and the employment rate and household debt at record levels, but they still want to keep rates at historic lows. The only reason they appear to have is that they don’t want the currency to rise too fast as this would endanger the inflation target. This seems to me to be an incredibly short-sighted policy, which has been shown to be unstable and dangerous in many places in the past, the UK most notably.

Sweden is a very open economy, and the currency certainly will have a significant impact on inflation in the short-term. But in the end keeping interest rates at a level that is inappropriate for the economy in an attempt to prevent currency strength is courting disaster. The result will likely be continued strong growth in the short run, further rises in household debt and above target inflation. When the brakes do have to be applied they will have the be applied that much harder, sending the currency up that much quicker. Or if the Riksbank choose not to apply the brakes, perhaps because inflation doesn’t rise too much, they result will ultimately be that the excessive debt burden causes a crash.

This isn’t just about Sweden, it’s also about the weakness of the policy of inflation targeting. The inflation process may well have changed significantly in recent years, with wage growth failing to ignite despite low and falling unemployment in Sweden and the Anglo-Saxon economies. The path from policy to the economy to inflation has not only changed, it may be almost completely blocked. Inflation is being determined elsewhere by other factors. Setting interest rates to control inflation in the short to medium term is becoming a ridiculous endeavour, and attempts to control inflation by controlling the currency are taking huge risks with the economy.

But it’s not even the case that the Swedish krona is particularly strong. The Riksbank likes to use the nominal KIX index, which shows the SEK slightly on the strong side of recent averages, and they cite the recent rally as one of the reasons for their decision in September. But measures of the real exchange rate show it to be very much on the weak side of historical norms. Attempts by the Riksbank to stop it rising are ultimately futile. Sooner or later it will return to normal levels, and it is better to allow it when the economy is strong and running a substantial trade surplus. A strong currency is a good thing – it makes consumers richer. They will be able to spend more without increasing their debt, and the trade surplus might come down. Instead, the Riksbank are following an unsustainable and dangerous policy, tying their policy to a region (the Eurozone) which is years behind Sweden in its recovery.

sek

Source: Riksbank, BIS

EUR/USD – Echoes of 2002

EUR/USD has bottomed out for the foreseeable future. At the beginning of the year I thought we might have another go at breaching parity on the back of further expectations of Fed tightening spurred by expectations of stimulative fiscal policy (and possibly protectionist measures) from Trump. The downside was nevertheless quite limited because the EUR was starting from very undervalued levels from a long-term perspective. Dips to parity even then looked likely to be a long-term buying opportunity. But with the break above 2015 and 2016 highs seen in July, the base looks to be confirmed technically, and the chances of a dip back below 1.05 – or even 1.10 – now looks like a long shot. The picture now looks quite similar to 2002 when the break through the 2001 and 2000 highs was the start of a 6 year rally of more than 70 figures to the highs in 2008.

Euro bears will be inclined to point out that the EUR was a lot lower then, but in reality the situations are not that different. In 2002 EUR/USD Purchasing Power Parity (according to the OECD) was around 1.17. Now it is 1.33. So, as the chart below shows, the difference from PPP at the lows in 2000 was not that much greater than it was at the lows in January this year. A little over 30 figures then, just under 30 figures this year.

eurusd and ppp

Source:OECD, FX Economics

Then, as now, the rally in EUR/USD frankly looked overdue. The case for the extreme USD strength in the early 2000s was based on a combination of the safe haven status of the USD, the uncertainty about the viability of the newly created EUR and the fallout from the 2000 crash. But by 2002 the major economies were all in the process of recovery and yield spreads, which are usually a reliable determinant for EUR/USD (and its precursor USD/DEM) were suggesting EUR/USD was substantially undervalued. Things are different now in that the yield spread doesn’t show a clear case for a higher EUR (though the US yield advantage is less clear when looked at in real terms).

eurusd and tnotebund

Source: Bloomberg, FX Economics

However, whereas the Euro area then was a region which only had a broadly balanced current account, it now has a massive current account surplus of around 4% of GDP (similar to the US current account deficit at more than $400bn). In the past couple of years this has been more than offset by portfolio and direct investment flows out of the Eurozone, and reports suggest that sovereign wealth funds have substantially reduced EUR weightings since rates turned negative. However, with monetary accommodation now looking more likely to be reduced, and European equities looking considerably cheaper than those in the US, these capital flows may well start to reverse before long.

This doesn’t mean EUR/USD is about to embark on a 70 figure rally over the next 6 years (as it did in 2002) and hit 1.75 in 2023. For the recent recovery to extend much further we are likely to need a significant narrowing in yield spreads, and this may still take some time as the ECB aren’t likely to be in a big hurry to remove accommodation. It is unlikely that the ECB are going to be too concerned about the run up in the EUR seen so far – it is quite minor on a multi-year scale, and the EUR remains quite cheap by long-term standards, but the pace of recovery may be a concern, because that will impinge on inflation in the short run. This could slow any ECB tightening, but the ECB must accept the likelihood of a long run EUR recovery. Nevertheless, EUR/USD should now be seen as a buy on the dip from a long term perspective. 1.10 looks unlikely to be breached again, so anything near 1.15 should be a buying opportunity.

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

The UK needs a weak pound

UK Chancellor Philip Hammond welcomed the rise in the pound that accompanied the announcement of the UK election last month. He should be careful about cheerleading GBP strength, because right now the UK is more in need of a weak pound than it has been for a long time, and a significant recovery in GBP could be a big problem for the UK economy.

The UK economic situation is dangerous, not only because of Brexit, but because of the perilous position of the UK’s consumer finances. This is well illustrated by the chart below showing the financial balances of the three sectors of the UK economy, balanced by the position with the rest of the world.

sector balances

Source: ONS

The UK household deficit is at record levels, and as can be seen from the chart, the existence of a deficit is a rarity, seen only briefly in the late 80s and then for a few years in the mid 2000s. It is a danger signal. In both cases, the deficit was followed by a recession, as consumers retrenched, as can be seen from the chart below.

householdbalance and GDP

Source: ONS

The process see in the past is instructive. Most of the time, GDP grows as the household balance moves towards deficit, fuelled by deficit spending. However, when the household balance moves into deficit, it tends to reverse, and this has historically led to a recession. If this is not to happen this time around, the inevitable reversal in the household balance must be accomplished slowly while other sectors are adding to growth. With the government constrained by longer term budget issues, this really only leaves investment and net exports. This makes the danger from Brexit fairly obvious. If firms are worried about access to the single market then investment in the UK may be curtailed. Longer term, the terms of Brexit will be key for net exports, but shorter term, the export sector looks likely to be the healthiest, as UK exporters benefit from the combination of a lower pound and strengthening Eurozone domestic demand. But this is why a significant recovery in the pound is not desirable. It would both undermine export growth and discourage investment.

Is a recession inevitable when households retrench? Not necessarily – it will depend on the conditions. In 2000 when the dotcom bubble burst the UK avoided recession in spite of a very extended household sector which did retrench, because rate cuts encouraged firms to borrow. But this underlines how important business confidence is in the current UK cyclical situation. With no rate cuts available to encourage businesses or households to spend, confidence in the future is key if spending is to be maintained.

All this makes the timing of Brexit look extremely inopportune. In the mid 2000s, the household sector ran a financial deficit for a few years before the crash, but the crash was all the more severe when it came for that reason. If growth is maintained in the coming years ahead of Brexit, the situation will be similar when Brexit actually happens. If Brexit hurts exports and investment, there will be no safety net.

Policywise, this should make it clear to the government that “no deal” with the EU is not an option. The fear is that they will  believe their own publicity and see limited economic damage if they fail to get a deal. Or take the view that, politically at least, falling back on the WTO will be favourable to accepting a deal that is like EU membership only worse. Hopefully sense prevails.

But in the meantime, the UK economy needs to be managed into a position where it can deal with a potential shock. This means managing a retrenchment of household finances now – while exports are strong enough to offset the negative growth impact. Unfortunately, it is hard to think of a policy mix that will achieve the desired outcome of slower consumer spending with strong exports and investment. Higher rates would help increase saving, but would also likely undesirably boost the pound. Higher taxes wouldn’t reduce the household deficit, only consumer spending, but would give the government more scope to react to shocks in the future, so are probably desirable. Direct restrictions on consumer borrowing might also make sense. But a stronger pound would not be helpful. Hammond should not be talking it up.

UK retail sales – the beginning of a slump?

Unusually I think it’s worth highlighting a monthly release. There is a lot of randomness in most monthly data and UK retail sales is one of the most vulnerable to monthly glitches, often because of seasonality problems. However, if you look at a 3 month average of sales the trend has been quite clear in recent years, until the last couple of months where it looks like everything fell off a cliff.

uk retail

Source: ONS, FX Economics

Now, it’s as well to be cautious in interpreting such sharp moves in retail sales, especially around the turn of the year when Christmas effects can be unpredictable. The plunge we have seen is really based on just a couple of months data. But as can be seen from the series, it is rare for the 3m/3m trend to move so sharply. If we see a similar story in March it would be fair to conclude that there has been a clear weakening in the trend.

Which leads me to the March data due for release tomorrow, Friday April 21. Looking at the screens today, the market median expectation for retail sales is for a m/m decline of 0.2% in the headline number, and a 0.4% decline in the core. Now, this seems to me to be quite a pessimistic forecast. The impact on the 3m/3m growth rate would be minimal, as shown below.

UK retail march

Source: ONS, FX Economics

Retail sales only makes up around 40% of personal consumption, but even so, a 1.2% decline in a quarter is quite a serious slump. Even if we assume the rest of spending carried on as before at the 0.7% q/q rate seen in Q4, then this would still mean negative consumer spending growth in Q1. As I was last month, I am a little sceptical that spending has been quite that weak. Last month we got a rise of 1.4% m/m, which was still far too little to prevent a sharp weakening in the 3m/3m trend, but was nevertheless well above the monthly forecasts. Markets saw this as good news, simply because the outcome was better than expected on the month, but it’s very hard to see how this sharp weakening in the retail sales trend is actually positive news for GBP. This month we may get more of the same. It would take something above a 3% m/m gain to prevent retail sales falling q/q in Q1. But a better than expected outcome of a 1% rise or so seems quite likely, as this would still mean a fall of 0.75% q/q. But surveys don’t suggest any major recovery, with the BRC survey showing the weakest quarter since May 2011 for non-food sales.

So we might get a knee jerk positive reaction because the monthly forecasts once again look quite weak and the m/m rise may be better than forecast. But any positive GBP reaction could prove a selling opportunity for GBP as the strength of the UK economy that Theresa May and the IMF have been telling us about in the last week looks to have come to something of a shuddering halt in Q1. Who knows, this may be another reason that May has called an election now. There are initial signs of a slowdown, and she may want to get an election in now in case they become more obvious in the coming months and years. We are in the sweet spot when it seems consumer confidence is still high, or at least was until Q1, exports are getting some support from a weak pound and there are as yet no negative consequences of Brexit to deal with. Things might not look so rosy in a few months.

UK election – GBP surge may last a while but…

maycorbyn

So May calls and election, saying she’s fed up with having opposition from the – er – opposition, and also from the Lords. Someone should tell her an election isn’t going to have much impact on the unelected House of Lords, but it’s true it may have the desired effect on the House of Commons. In practice, she is likely to increase her majority because even though she may lose a fair few seats in the South to the Lib Dems campaigning on a Remain ticket, she looks like picking up a lot of Labour seats in the North, and also gaining votes from UKIP now the Tories have become the party of Brexit.

What I find depressing is the process of British politics. I suppose it is no surprise that politicians are power hungry – it is in their nature – and they will grab as much as they can given the chance. That is probably true pretty much everywhere, but let’s not pretend there is any higher motive for the election than that. But it is particularly depressing in the UK, where the first past the post system means the governing Tory Party already has a degree of power that is unrivalled is the vast majority of western democracies which generally have some form of proportional representation. The desire for an even bigger majority than the 17 the Tories currently have, so that there is no effective opposition at all (even within the Tory Party) is, in my view, faintly obscene, but that’s (British) politics. What is mystifying is why Corbyn and the Labour Party seem so happy to accede to her wishes. Sure, he was calling for an election after the referendum, but she refused. Now he should refuse. That’s the point of the Fixed Term Parliament Act. The timing of the election should not be based on the whim of the governing party (or any other party). His agreement to an election just underlines that Corbyn is a political idiot.

Anyway, it looks like May will get her wish and get an election and a bigger majority. The market consensus is that this is a good thing in practice, because it will give her more negotiating power at the Brexit table. This is true, in that there will be no election looming over her as the end of negotiations approach. However, the idea that she will take a more moderate and compromise friendly approach because she will be less dependent on her right wing looks a little speculative to me. It’s possible, but I don’t detect an air of compromise in her recent statements. I think it’s just as likely that the elimination of an effective opposition will allow the government to take a much more hard line approach. The security of the Conservative political situation domestically will allow them to indulge prejudices that are not necessarily optimal for the long term health of the economy.

While she will of course say she wants the best deal for Britain, what does that actually mean in practice? No-one really knows what the best deal is. Although the vast majority of economists believe something as close as possible to Remaining would be best economically, it is clearly not just about economics. In fact, it is probably not about economics at all. For politicians, the best deal is the deal that will given them the best chance of winning the next election with the biggest majority. The economic impact of Brexit may be large or may be small, but it will not be easily observable because there is no counterfactual. We won’t know what a good Brexit looks like any more than what a bad one looks like. We won’t know if Remaining would have been better. Even if the next election isn’t until 2022, the economic impact very likely won’t be clear by then.

But some things will be easier to measure. The level of immigration for instance. If the government manage to restrict immigration significantly they will probably benefit in the polls (regardless of whether that is actually beneficial). If they win the June election with an increased majority it seems likely to send them a signal to continue to work the nationalistic angle. This is not a conviction government. May has U-turned on Brexit and U-turned on an election. She will go with what works, and if she can sell an image of the UK battling for independence from a sclerotic Europe she will do it. I could easily be wrong here, but markets must beware of believing politicians are thinking about the economy. They are thinking about politics, and right now the economics isn’t clear enough (at least to the layman voter) for that to be the main factor.

As far as FX is concerned, for now at least, there’s no point bucking the market consensus. GBP is benefiting from the more positive view of Brexit, helped in large part by the heavy short positioning that has been evident for some months in the futures data. Some of that has now been eliminated, but the wind is still with the pound. I stick with the view that there isn’t much long term value in the pound here, but there may still be some more upside in the short term. In the absence of news from the US on tax reform the USD looks to be on the back foot for the moment, with expectations of Fed hikes fading, and we are likely to see GBP/USD gains beyond 1.30.  The EUR’s near term chances depend largely on the French election. If Macron gets to the second round he should win and the EUR should benefit modestly from this, but will suffer sharply if the run off is between Melenchon and Le Pen. On the positive EUR outcome I would see EUR/GBP as a buy below 0.83.

Looking a little further forward, the election may not be quite as smooth a victory as the polls currently suggest, and the current perception of the strength of the UK economy seems to be lagging behind what looks like a fairly sharp consumer slowdown in Q1. I would still be looking to sell GBP post election, or possibly before if the current euphoria dies down or we have some positive developments for the EUR or the USD.

 

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.

GBP isn’t cheap

Over the last few weeks and months I’ve noticed quite a few commentators suggesting that GBP might now be attractive because it is very cheap. For instance “the pound looks increasingly “cheap” in a historical context” (Morgan Stanley March 7). “The pound looks cheap at current levels” (ANZ December 6). “The pound is looking “cheap” from a longer-term point of view” (Scotia Bank March 2). There are plenty of others. The consensus seems to be that the pound is cheap because it is suffering from Brexit woes, and that if those were to fade, or be overtaken by concerns elsewhere in the world, the pound would recover. But I would argue that although the pound is obviously cheaper than it was, it still isn’t really cheap against most of the other major currencies.

If something falls a lot it doesn’t necessarily mean it is now cheap. It’s possible of course. But it is also possible that it is falling in line with long-term equilibrium – i.e. it is no cheaper than it was. Or, more likely, it could be that it has fallen from expensive levels and is now just less expensive, or fair. How to decide? Well, some sort of sensible model of fair value is necessary, otherwise we don’t know where we are starting from, or what affects long term equilibrium.

A lot of people run a mile as soon as they see the word “model”. Models are distrusted. So I’m not going to create anything complicated or use any fancy econometrics. I’m simply going to point out three things.

  1. It is the real value of a currency that matters, not the nominal value. This is just another way of saying that if prices rise in one country or currency area relative to others, then unless the currency falls, things are now more expensive in that country/currency area. In other words, to keep the real value of the currency stable, currencies have to fall if relative inflation is high in their area.
  2. Trade balances and current accounts matter. The bigger your current account deficit the more capital you need to attract to finance it and, other things equal, the lower your currency has to be.
  3. Interest rates make a difference. If you have higher interest rates than others there will be more demand for assets denominated in your currency. This ought to apply to real interest rates (interest rates minus expected inflation) rather than nominal rates, because future inflation would typically lead to currency depreciation (point 1).

I don’t think anyone would argue with these three points. But if these are accepted, I don’t see why people see GBP as cheap.

Point 1 is really the most crucial. While terms of trade and interest rates are clearly important, the impact from changes in export and import prices can take some time to be felt and can be offset by other flows. Similarly, interest rate variations affect short-term demand, but if such variations are cyclical they may not have much impact on long-term value. But where we are starting from in terms of the real value of the currency is critical.

So where does the pound stand in real terms? There is more than one way to measure this, but I will use two main methods. First, let’s looks at the commonly used measure of the real effective exchange rate. The chart below shows the narrow real effective GBP exchange rate, and on the face of it, GBP does look quite weak by historic standards. But looking at it next to the EUR effective exchange rate, it isn’t so clear. Since the financial crisis the EUR has weakened more on a trade weighted basis than GBP. Even more dramatically, the USD is well above the highs seen in the last 20 years

realeffective

Source: BIS

So what’s going on? Well, a little more light is shed if we look at another measure of value – namely GBP versus purchasing power parity (PPP). Below is a chart of EUR/GBP against EUR/GBP PPP.

eurgbp ppp

As this shows, EUR/GBP remains some way below PPP. This is not unusual – it has only briefly traded above PPP in the past. This is itself a little puzzling, and I would argue that it is hard to justify, of which more later. But even taking that as given, EUR/GBP is only marginally stronger relative to PPP than its average in the last 20 years.

So GBP isn’t really weak against the EUR at all. What we are seeing here is not GBP weakness, but USD strength.

This is all the more obvious if you look at GBP/USD relative to PPP, shown below.

gbpusdppp.png

The USD is as strong against the pound (relative to PPP) as it has been since the 80s and the Reagan era. But the USD is strong against (almost) everything. Only the CHF among the majors looks stronger relative to long run fair value.

Now, USD strength is based on the cyclical strength of the US economy, and to that extent is justified in the short to medium term because US interest rates are higher than the UK and Eurozone, and rising. While the UK economy is (arguably) similarly strong to the US, given low levels of UK unemployment, the UK doesn’t have the interest rate advantage. Indeed, real UK rates are the lowest in the G10. Not only that, but the UK also has a massive trade and current account deficit. The chart below illustrates the situation.

yieldcascatter

Source: OECD. Real rates based on 2018 forecasts of PCE deflator

The further north-east you can get in this diagram, the more attractive your currency should be. A big current account surplus, like Switzerland, will normally allow you to have low real rates while high real rates, like New Zealand, will normally allow you to run a big current account deficit. The UK is currently enjoying the worst of both worlds. It’s also noticeable that real rates in the US aren’t all that attractive, and may not be high enough to justify the very high level of the USD. As far as the EUR is concerned, there are clearly other issues at play, including existential concerns. But without even considering the potential future negative impact of Brexit (though of course some of this is included in the real yield), it would make sense for GBP to be well below fair value. The fact that it still trades well above PPP against the EUR, and close to it against the USD, suggests it is far from cheap.

What will it take for the CHF to weaken?

real-chf

Source: BIS

Equities have certainly had a good run this year so far, and there should still be more to come for European equities as long as the European economy continues its modest growth, with EuroStoxx still well below its highs and value relative to bonds looking excellent. But despite the strength of equities and good Eurozone data, EUR/CHF continues to test the lows, even on a day when the Swiss GDP data reports a disappointing 0.1% q/q and 0.6% y/y rise, underpinning the expectation of continued easy Swiss monetary policy. Why is the CHF so strong?

Well one reason is likely to be concern about European politics. The markets seem to have got themselves in a state worrying about the possibility of a Le Pen victory in France and even about Wilders in the Netherlands. People explain their concern by pointing to the victories for Brexit and Trump as illustrations of the populist movement sweeping the world and the unreliability of polls. But Brexit and Trump were not huge outside bets according to the polls. They were marginal outside bets. Sure, the markets seem to have treated Leave and Clinton as foregone conclusions, but that was never justified by the polls, which always suggested the votes would be close. But the polls don’t suggest Le Pen will be close to winning the French presidency. They suggests she needs to turn around 8 million French people Fascist in the next 2 months to win. That isn’t just unlikely, it’s wildly improbable in a way that the UK “Leave” vote and the US vote for Trump never were (at least not once he was the Republican candidate). Similarly, Wilders Freedom Party could just about be the largest party in the Dutch elections, but has effectively no chance of forming a coalition as no other party is prepared to join with them. Even with their most optimistic poll results, they will need double the seats they would achieve to form a government. So worries about European politics seem overblown, and European equities seem to get this, but the Swiss franc nevertheless remains near its highs.

This is puzzling because the Swiss franc is normally seen as a safe haven. Valuation wise it is always expensive relative to purchasing power parity (PPP) because it is seen as so safe. But safe havens will normally weaken in risk positive, strong equity environments, because safety is in less demand. The Swiss franc is a little weaker than it was at its peak, but it is lagging well behind the recovery in the European economy and European equities, even though yield spreads remain very unattractive with Swiss yields significantly negative out to 10 years.

 

So what will it take for the CHF to fall to more normal levels? The underlying problem is that money has stopped flowing out of Switzerland. Normally, surplus countries like Switzerland see heavy portfolio outflows looking for better returns elsewhere in the world, but the Swiss balance of payments data shows that portfolio outflows have effectively dried up since the crash. The SNB’s intervention has dealt with speculative and hedging  flows – captured in the “other investment” category of the balance of payments – but until portfolio outflows recover properly they will not be enough to cover the current account surplus – which remains substantial. This will be required if the CHF is to reverse its uptrend. Of course, it would also at some stage make sense if the speculative flows that have gone into Swiss francs – making a tidy profit – were to go out as risks decline and appetite for foreign assets returns. This other investment category has totalled more than CHF410bn since the beginning of 2008, and has been offset by an increase in reserves of more than CHF600bn. If confidence returns, this cash should flow back out and push the Swiss franc back to fair value, which is around 10-15% below current levels.

When will this happen? Well there are obviously a lot of uncertainties. But if Le Pen doesn’t win, and Trump/the House Republicans produce a detailed infrastructure/tax reform proposal by the Spring the Swiss franc could be under pressure from May for the rest of the year.

swiss-bop

swiss-bop2

Source: SNB

Canada (and CAD longs) should be worried about the US border tax

usdcad

Trump has talked a lot about Mexico, imposing a border tax  and getting them to pay for the wall. USD/MXN has reacted aggressively, and although it is off its highs in common with the general USD dip in recent weeks, USD/MXN is still 60% higher than it was 2 years ago. But it seems to me the market ha been overly focused on Mexico when it comes to Trump’s trade policies. While he has been very vocal on the possibility of a tariff on Mexican and/or Chinese goods, the actual plan for a border tax adjustment looks much more likely to be along the lines proposed by the House Republicans. This would be part of a general tax reform involving a cut in the corporate tax rate to 20% and a “border adjustment tax” of 20%. Such a tax would likely be charged on all imports (while all exports would be tax-deductible) regardless of where the imports come from. It seems unlikely the new system would be focused on Mexico or any other single country. As such, it seems the reaction seen in USD/MXN is excessive relative to the reaction seen in other currency pairs.

This sort of tax is normally associated with consumption tax based systems like VAT. In that case, a tax is added to imports to level the playing field with domestic goods on which VAT has been charged, while exporters get VAT refunded. Although the US system isn’t a consumption tax based system, the idea is to switch the US system to a territorial system in which companies are only taxed on revenues earned domestically rather than the current worldwide system in which US companies are taxed on all revenues. The argument is then that the system (a destination based cash flow tax or DBCFT) will then be broadly equivalent to a consumption based tax system. There are several technical arguments about deduction for wages and land which mean that this is probably not correct, and the tax my consequently be against WTO rules. This may be a problem for the system in the long run, but establishing whether it breaches WTO rules and generating a response will take some time, and the short to medium term impact of such a policy, if implemented, is likely to be significant.

If such a system is implemented, it will immediately increase import prices and reduce export prices. From a trade perspective, it would effectively be equivalent to a devaluation of the USD by 20%. The academic response from trade economists to such a policy is that the market reaction would be for the USD to appreciate by 20%, leaving everything real effectively unchanged. But in practice this won’t happen. The level of the USD doesn’t only affect trade, but also asset values and capital flows, and changes in such flows in response to moves in the USD are often larger and almost always faster than changes in trade flows. It is also the case that some of the reaction has already happened, notably in the MXN. Even so some currencies are still likely to be affected if such a plan is put into practice, as it may be in time for the 2018 tax year.

While some impact can be expected on many currencies, of the liquid currencies the CAD seems much the most vulnerable. 75% of Canada’s exports go to the US, making up 4% of its GDP, so such a big move in the terms of trade would have a huge impact. Unlike USD/MXN, the CAD doesn’t start from a position of being cheap. The consumption based PPP for USD/CAD is around 1.30. Other major currencies may also be hit, but they are all less exposed to trade with the US. Many also start from a cheaper level (notably the EUR) and are more capital market determined (the EUR and the JPY). From a risk perspective, if such policies are perceived as damaging to US growth, the CAD could also be expected to suffer from the impact on risk appetite and commodity prices. Add to this the fact that the CAD has strongly outperformed rate spreads this year (see chart), so will probably weaken anyway if the market takes a positive view of Trump/Congress tax and spending plans, and the potential upside for USD/CAD looks substantial.

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. 

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.

us-cpi-real-yields-1us-cpi-real-yields-2cpi-and-real-yields

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 

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.

 

 

A crisis for UK democracy?

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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

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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

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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.