A EUR/USD for Your Thoughts
I am sure it has not escaped your attention that yesterday saw the EUR/USD move above and beyond the magic 1.50 mark. In fact, in time of writing it is trading at a smidgeon above 1.51. And by all means, the Euro is not the only currency sticking it to the USD at the moment. The USD/AUD is trading at 0.94 and the USD/JPY is fast approaching the 105 level. So, we are once again finding ourselves in the situation where the USD is taking a beating against just about anything which moves. At the heart of this is of course the divergence nature, or decoupling if you will, of monetary policy between a Fed cutting aggressively to avoid a recession relative to the ECB et al. which at least to some extent attempts to focus on inflation. As such, this has little to do with de-coupling in the traditional sense of the word where Europe and the rest of the world unhinges from the US to carry forward the baton in the form of consumption driven growth. Rather, what we have is a bet on the continuation of the widening interest differential between the Fed and the ECB and thus ultimately a hunt for yield. There is consequently a short term and a long term correction in play here and at some point these two lines will obviously intersect.
So what was it exactly that prompted the EUR/USD to rally beyond 1.50? Surely, the future expectation of further rate cuts by the Fed could not have done it itself since this was pretty much a foregone conclusion. In my opinion an above consensus reading of business confidence in Germany was probably what cracked it for the USD since it paired the few expectations that the ECB would cut come next meeting. On top of that, the incoming data from the US economy has been devastating to say the least which was probably also why Bernanke today, in a much scrutinized speech, pretty much pledged that he would move in with further cuts come March. All this points to further Dollar weakness in the short term. The interesting point here has always been the extent to which a correction in the short run in favor of the Euro relative to the USD could lead to more widespread and structural changes such as for example that the petro exporters and/or China would finally de-peg or perhaps even diversify into a more balanced peg with higher weight assigned to the Euro. If we look at what has actually happened since the ECB and the Fed parted ways in August 2006 it appears that the latter scenario has been the one standing out from the data. A notable example is China's trade surplus which has grown substantially more with Europe than with the US but once again I stress that this process is far from having been tested in its full resilience. Moreover, and while everybody with even a most basic understanding of macroeconomics can understand the impetus for the USD to fall to correct a steadily widening external position nobody has really asked themselves who in fact was going to take up the slack from the US and her imports. It has merely been assumed ex ante that this role was destined to fall on the shoulders of Europe and the Eurozone and that such a correction would entail absolutely no adverse consequences. Or put it another way. To move from Euros into USD on the short term end of the curve in order to pick up yield is one thing but to expect this yield difference between the Eurozone and USD to persist is another. Ultimately, this is also why the US is able to keep the boat floating I imagine on the back of those official inflows from foreign central banks and sovereign wealth banks since these institutions are not ready to exercise their put option and knife the USD even if red hot asset markets and elevetated consumer prices would prescribe that they did. They are not ready to do this for two reasons. One is the sheer volume of their reserves and the simple point that if a major reserve diversification occurred in favor of the Euro and the Yen it would effectively mean that Italy and perhaps other weak economies would have to leave the Eurozone. In short, the yield advantage of the Euro underpinning such a move would most likely be nullified by the ECB's lowering of interest rates or a major reschuffle of the Eurosystem. In fact, what we are seeing now is a derivative of this process. Secondly, the Dollar peggers cannot come off their hooks simply because they don't have the possibility to re-cycle the reserves into their own economies not to to speak of the run on currencies themselves in a situation where trading was suddenly freed and the money inevitably would be pouring in. In this light, I think we need to remember the numbers here. We are talking trillions (!) if you remember and I cannot understand why these major players in the global system should not be able to both keep the bond conundrum alive as well as struggling investment banks and other equity/debt classes. If there ever was excess liquidity I think this is where we should be looking for it. However, this is not a question of padding the Fed on the back assuring Bernanke that inflation need not be a concern. It does indeed. Yet, we also need to understand that just as well as the US is in the midst of a correction so is the global economy. In a note on the global economy I thus noted recently ...
So, we can all see the impetus for the steady erosion of the Bretton Woods II in its current form and but this also carries with it two very important side issues. Firstly, is this the end of the US economy as we know it? Most emphatically not and while the US almost certainly is set to see its role as number one drift steadily away it is in no way toast and headed for perpetual decline which I am afraid might end up being the result for other economies. Rather the US economy will adapt to its new position and this ultimately should be the real lesson for the global economy; watch out export dependant Japan and Germany! This would then bring us to the second point which centers on what happens in the interim. One thing which of course has struck me is the extent to which global liquidity has moved in favor of Japan and the Eurozone as the new shoulders of the Bretton Woods II system. Clearly, I think this is quite unsustainable but until we get to whatever kind of 'equilibrium' we have in store it could be a bumpy road indeed.
Edward also makes a similar point in a recent note ...
Basically, as I have been arguing, there are two opposite tendencies at work here. A short term one for the dollar to fall vis a vis the euro, and a longer run one whereby both of them have fall against an as yet unspecified basket of currencies. The basket may be unspecified, but my guess is that the rupee and the real will be in it. Possibly the Turkish lira. In fact how all this might pan out is that those who are left in the basket of emerging market currencies tracked by Bloomberg after the coming correction is over (ie, for example, after Eastern Europe has been forcefully stripped out) might well go to form the emerging nucleus here. So market realities rather than G7 policy may well be the final determinant here, which I suppose, given the zeitgeist of the times, would only be appropriate.
Moving on, a by product of all this in the form of the tendency to go for yield has thus ironically turned the workings of monetary policy upside down; something I'd wish those among us with Austrian inclinations should take into account in their analysis. Quite simply, vigilance against inflation in the current environment has highlighted the rather peculiar nature of global liquidity conditions at present in the form of a disconnect. Citing my post linked above I take the liberty to quote myself again ...
... it seems to me that what we have is a great disconnect in the global liquidity channels. On the one side the subprime turmoil has had, as one of many, the nasty side effect that the interbank market has dried almost entirely up. This might to many seem a technical issue but quite simply the modern financial system needs a certain amount of liquidity to work smoothly and in the present situation the liquidity is just not there.
This situation which has gripped the fear by central bankers across the globe stands in stark contrast to what you could call the general liquidity situation in the global economy. As such, I want to remind my readers that it was only back in the early Spring of 2006 that the talk of the town was excess global liquidity as the three major central banks G3 (BOJ, ECB and the FED) embarked on what was widely seen a mutual crusade to mop up the excess global liquidity or as it was noted to begin the process of interest rate normalisation. Of course, a lot of water has gone under the bridge at this point and we shall not dwell extensively by it in this entry. However, what remains is then, as I noted, somewhat of a disconnect since if you look at the current trends in inflation as well as general liquidity conditions in some parts of the global system it could indeed seem as if, as Edward so aptly put it in recent in the context of Russia, that too much money is chasing too few people.
As should be readily clear from the points above the global economic edifice is a little bit more complicated than just watching the EUR/USD nudge higher as a sign of de-coupling even if of course money can be made either way you see it. You simply need to be on the right side of the fence. However, what about that EUR/USD and the Eurozone then? How long do we expect the ECB to hold its guard? On the EUR/USD the break of 1.50 has shattered all kinds of barriers in both technical and fundamental terms so from here on it could go anywhere. The ECB's inflation watch-dog Axel Weber was out today swinging the tomahawk noting how investors shouldn't be banging the doors in Frankfurt for relief. Meanwhile of course, the incoming data is flooding the channels with bearish news from just about every corner of the European edifice be it in Eastern Europe or the Eurozone economy herself. Especially Italy now faces a prolonged slump as well as Spain seems to be moving closer to the shredder. With inflation running well above comfort level it merely further illustrates the debacle in which the ECB finds itself. Interestingly, this bind has also made me think about the theoretical grounds for monetary policy. You see, there are two general ways in which 'theory' prescribes that monetary policy is conducted. The first and this is one most central banks claim they are abiding to is the so-called instrument rule. This would be the good old Taylor rule (or a derivative thereof) in which you set the rate according to a well specified target for inflation and the monetary supply (M3). However, there is another approach too which of course seems to have drifted out of the limelight even if you can argue that the Fed is following it at the moment. Here we imagine a loss function which at any given point in time needs to be minimized using the monetary policy rate as a tool. The interesting thing here is the way in which the model is constructed. In essence, we simply assign different variables into our function with a given weight (ultimately amounting to 1.00 of course) and then minimize the function using the rate. This is all conceptual although much of the literature naturally embarks on very rigorous mathematical techniques to come up with the optimal policy rate. Now, in terms of the variables inflation and unemployment have naturally been important in themselves and given the well known (at least in theory) trade-off between the two much of the literature has been on the exact and optimal weight between the two. Other models again have been conceptualized in connection with emerging markets and the tradeoff between revaluing and defending the currency in the context of an impending currency crisis. Yet, and here is my main point. Clearly, the ECB only has inflation in this function at present even though of course the 'growth' variable and perhaps even the EUR/USD variable are pressing too. But why don't we get more to the point. How much does Italy's situation weigh in this 'function', how much does Spain's potential mortgage crisis, and what about Eastern Europe?
I certainly would not venture a steadfast answer but it does bring me back to an enduring gripe of mine. One interest rate for all the Eurozone countries just seem to be too simple a policy tool even if we think (and I most emphatically do) that the Euro as a currency and medium of exchange is a force of many good things.
Last time I had the Eurozone under scrutiny was in connection with the Q4 GDP release where I ventured the claim that the EUR/USD would remain sticky around the 1.46-1.47 band. I also mentioned how business confidence surveys and inflation readings would be important in determining whether it went (up or down). The Italian business confidence indicator took a trip to the basement but the German ditto showed a slight pick up and coupled with the ever incoming slew of above target inflation readings this was what cracked it for the EUR/USD. The value band hitherto mentioned has consequently well and truly been broken and what happens from here is anybody's guess. The next couple of days sees a whole slew of important data from the Eurozone as well as the US and since the ECB will be next to decide on interest rates (a definite hold I think) it may move either way with clear bias and momentum to an appreciation. However, the important point to take away from the note above is the subtle interaction between short term and structural factors. What really matters in this context is when these will meet each other. My guess is that the ECB will be pushed to lower rates in the first half of 2008 but this is as much a question of timing as anything since everybody agrees that the ECB will lower over the course of 2008. What would happen to the EUR/USD then will be very interesting to watch. Surely, the ECB is now in a position where any signs of easing could cause plenty of those violent currency movements of which Trichet has explicitly noted his dislike. Meanwhile, we need to keep our eyes fixed on the economic fundamentals. At this point and as I have argued before the ECB has chosen to stand firm on the inflation front so far neglecting the signs from the real economy. The consequences of this are likely to be, at least, a recession in Italy. What comes next from here will be confirmed further by incoming data but at this point I don't think we should be overly optimistic.