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.

Policy mistakes should not always be reversed

cpimktfeb17-1

UK inflation is rising

The Bank of England cut rates by 25bp and increased asset purchases in August in anticipation of a loss of confidence after the Brexit vote on June 24. The objective was stated to be to “provide additional support to growth and to achieve a sustainable return of inflation to the target.” Subsequently, growth was substantially stronger than expected through the remainder of 2016, mainly due to strong consumer spending, funded by increased borrowing. Now, many (including myself) thought the cut was a mistake at the time. But we all make mistakes. The Bank’s assessment of the impact on confidence appears to have been incorrect. Of course, some might argue that growth was stronger because the Bank eased policy, and no-one can prove that is wrong, but I think it is far-fetched. The fact is that the majority of the population (or at least half) are in favour of Brexit, so there is no good reason why the vote should have undermined consumer confidence. Business confidence might have been damaged in the longer run, but very few investment decisions are changed in a short time frame, so if there is a negative impact, it is yet to be felt. In practice, the relative resilience of spending may convince businesses to hold their nerve until the new trade arrangements become clearer, which may well take some time, as long as growth doesn’t start to slip back.

So it certainly seems as if the Bank of England made a policy error. While there is still very likely to be a longer term supply side shock from Brexit, that may not happen for quite some time, and the demand side shock the Bank initially expected has not materialised thus far. So what should they do? Should they reverse their easing and admit their error? The latest Inflation Report certainly shows inflation is expected to move above target soon and stay above target for the whole forecast horizon, which would suggest there is a pretty good prima facie case to raise rates or at least halt the increase in asset purchases. But the best way to fix an error is not always to simply reverse policy. Unless the reversal is done very quickly, the environment faced is different from the one faced initially. Things have changed.

In this case, the most notable change has been the decline in the pound. This has been good in some ways, as it has helped sustain manufacturing an export confidence in the face of uncertain future trade relationships, but it will lead to substantially higher inflation going forward, starting quite soon, as higher import prices feed through to CPI. It has also already led to higher inflation expectations. The key question as to whether this is sufficient reason to reverse the policy easing is whether the coming rise in inflation leads to an increase in wages and other factors generating domestically generated inflation. At this stage this is not clear, and is important. If wages don’t respond, we will see a sharp decline in real income growth as inflation rises, and if we also see a rise in rates from the Bank, there is a danger this will lead to a sharp decline in consumer confidence, potentially at the same time as sterling rises in response to a rise in rates. This could make the current optimism about the UK economy evaporate quite quickly.

So at this stage it seems sensible to wait. Inflation is coming, and it would be as well to see how this impacts spending and confidence before acting to reverse the move made in August. There has been a lot of British bravado since the Brexit vote, but high levels of debt and declining real incomes, plus the uncertainty surrounding the trade relationship with the EU and elsewhere, suggest that confidence is likely to be fragile. After making a policy mistake it is important not to compound it. The Bank mustn’t act looking in the rear view mirror.

 

 

Corbyn’s cap is a bad idea

corbyn

This is not just a fashion statement, though the Mao style cap is not likely to endear Corbyn to Middle England or improve his electoral chances. It also refers to his idea of a wage cap at somewhere between his own salary (137k) and 50m. He sensibly backed away from that idea as the day went on yesterday, but unfortunately has tarnished the whole idea of dealing with excessively high pay with his ill thought out plan. Excessive  pay is an important issue, but the key point is that it is excessive, not that it is high.

He gave footballers’ high pay as an example, but footballers’ high pay is a very poor example. Footballers are talented, and are paid a lot because their talent is in demand. Their ability is broadly measurable and certainly observable, even though there may be some disagreements about the contributions that players make, and clubs compete for their services in the open market. In general they are highly trained, have committed their whole lives to honing their specific skills, and are competing in an extremely competitive market. Pay is high, but reflects both high demand for their services and the very low probability of being successful.

Compare this with the chief executive of a large public company. The skills required are more amorphous. Leadership, strategic thinking, man management, and ruthlessness may all be required, but it is very hard to quantify whether CEOs are making a difference. If their companies are outperforming in their sector it may be a partial guide, but that may be because of their workers or company specific factors unrelated to them. Nevertheless, it’s necessary to measure performance in some way, and the company’s performance is a better guide to CEO performance than most, because the CEO’s objective should presumably be to maximise shareholder value (subject to some constraints of acceptable behaviour). Other employees can no doubt have more specific objectives, but for CEOs the bottom line should be the…er….bottom line.

But the argument many give for paying CEOs of large companies big salaries is that the larger the company, the greater the potential for the CEO to add value. If a CEO makes a decision that raises revenue by 1% it makes a difference of 100m for a company with 1obn in annual revenue, but only 10m for a company with 1bn in annual revenue. But this cuts both ways. If the company underperforms by 1% the CEO will be losing the company more money the larger the company is. This suggests that larger companies’ CEO salaries should be more volatile. Potentially larger but more dependent on performance. But you don’t see too many pay deals where the CEO has to pay the company money, so any deal has to accept that the CEO gets a basic salary that can only be increased by the bonus. On this logic, surely the larger the company the lower the CEO’s basic salary should be and the higher the gearing to performance.

Anyway, this is the sort of detail that Mr Corbyn didn’t seem to consider before jumping into the debate with both feet. A salary cap is precisely the wrong way of going about things, as it would just mean a lot of underperforming CEOs earning a lot of money regardless of performance. Admittedly this is not very different from the current situation, but with lower salaries, given the general lack of sensitivity of CEO salaries to performance. In that sense Corbyn is right in recognising there is a problem, but his solution was initially ill thought out, and subsequent attempts at a more sensible presentation of ideas have been tarnished by his initial floundering.

 

Trade ideas for 2017

sp-vs-eurostoxx50

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

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

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

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

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

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

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

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

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

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

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

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

 

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

ECB promises are worthless

draghi

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

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

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

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

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.