First, we told you that the FOMC
minutes were not as dovish as the dollar and US Treasury yields may have
suggested to many observers. Neither timing of the balance sheet
adjustment (Sept announcement) or the odds of a rate hike before year-end
changed. The dollar and US yields had been coming off following the
collapse of President Trump’s business councils.
Now we say that the market is
exaggerating the dovishness of the record of the ECB’s meeting.
The specific statement that raised the market’s hackles was: Concerns were expressed about the possible overshooting
in the repricing by financial markets, notably the foreign exchange markets, in
the future.” Draghi said at the time officials took note of the
euro’s appreciation. Was that a fair characterization of what the
record said?
Our operating assumption is that the ECB’s record like other central
banks’ minutes is not simply a transcript
of what was said. It is a communication tool. Thought is given
to what goes in it. There are
sufficient conditions in the ECB’s statement that is still a relatively low
level of concern. The overshooting was not
realized it was “possible.” It is not happening now but
could “in the future.”
The euro appreciated for five months in a row and six of the seven months
through July. In the prior seven months, the euro fell for five
months. On a trade-weighted basis, the euro rose about 6% through
July. The trade-weighted measure bottomed in late 2015 and through today
has risen nearly 12.5%. It has nearly retraced half of its decline since
2008.
Economists teach that purchasing power parity is the level that
currencies gravitate around in the long-run. The OECD’s model of
purchasing power parity for the euro suggests a fair
value for the euro is closer to
$1.33. It is about 13.2% undervalued
by this metric. What other level do currencies gravitate around in the
long run? A long-run moving average. Using monthly data, the
10-year moving average for the euro is now near
$1.2960.
Interest rate covered parity holds that currencies ought to move to
equalize underlying interest rates. The US offers 1.8% more than
German does to borrow your money for the next decade. If an investor
thought that the dollar would depreciate by more than the interest rate
differential, a Bund would be preferred
to Treasuries.
The analytic community often seems to swing between two broad models of
currency explanation: interest rates and external balances. Many
euro bulls have shifted from interest rate differentials, though that
explanatory model still seems to work.
The US 10-year premium over German has fallen nearly 50 bp since the end of
last year, while the two-year differential is practically flat.
Nevertheless, earlier today, the EMU reported a 22.3 bln euro trade surplus for
June. It is the highest here in 2017 and is half a billion euros larger
than the surplus in June 2016.
However, the underlying trend has begun weakening. In H1 16, the
eurozone reported an average monthly
surplus of 22.6 bln euros and 19.1 bln euros in H1 17. This is not to minimize the significance of EMU
trade surplus. Recall that in the H1 07, the period before the beginning
of the crisis, the eurozone recorded an
average monthly trade deficit of almost 173 mln euros. The German
surplus did not quite offset the deficits of most of the other members.
Now the German surplus is larger, and
many former deficit countries are running small surpluses.
Even if the euro is not overshooting and will not overshoot anytime soon,
there is still importance in the ECB’s
record. The sub-text is that the ECB leadership is laying the
groundwork for a gradual tapering and exit from the previously thought to be
unorthodox policies. The creditors, including Germany, have long
complained that monetary policy is too accommodative. Draghi and his
allies at the ECB are arguing that the backing up of interest rates and the
strength of the euro may tighten financial conditions prematurely. The
economic activity and lending still require,
they argue, much official assistance.
Our argument is that divergence is not only alive, but it has not
peaked. Making some conservative
assumptions, the Fed’s balance sheet will shrink $180 bln between Oct
2017 and end of June 2018. The ECB’s balance sheet is likely to expand by
about 360 bln euros over the same period. The Fed may hike rates two more
times (maybe three) before the ECB raises its negative 40 bp deposit
rate. Where there may be convergence is that Macron’s support in
France has converged and gone below Trump’s support in the US.