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


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.


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.


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?


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.



Source: SNB

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


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


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


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


  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.