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The global economy has experienced numerous shocks in the past few years. A global pandemic, a war in eastern Europe, and multiple bank failures, just to name a few of the major events that have shaped the world after 2020. Unexpected crises, such as the events just mentioned, require rapid action from institutions. Governments and Central banks answered. Whether these institutions have been acting correctly or not is hard to say, but it is worth analyzing how events have been unfolding in the two major Western economies, the United States, and the Euro-Area. In this article, I will attempt to explain the reasoning that convinced me to adopt a bearish stance on EUR/USD in 2021, and why I maintain the same bias on the cross. I am no financial advisor, and this article is the pure product of my personal opinions. I hope that you may find my thoughts interesting.
This article is a guest post written by Francesco Torin from BCC Banca Annia
The COVID crisis caught most institutions all around the world unprepared. Uncertainty was reigning supreme. In the Western world, governments decided to shut down national economies, in a desperate attempt to prevent the virus from circulating uncontrolled, and to massively subsidize businesses and citizens in order not to depress economic confidence. That led to massive government deficit spending and relentless money printing. The American debt to GDP ratio shot up from just above 100% to more than 130%. A symmetrical strategy was employed in the EU, where general rules of fiscal responsibility have been temporarily suspended. Both the FED and the ECB embraced an ultra-loose monetary policy, by cutting rates to zero and by expanding their balance sheets through massive purchases of securities.
Monetary aggregates rose at a pace rarely seen in history. Central banks’ balance sheets grew in size. It was inevitable at this point that inflation would have woken up. Both the US and the EU found themselves, by the end of 2021, in a structurally inflated economy. Aggregate demand was pushed too high for too long to just create a temporary phenomenon.
Up to this point, the two economies experienced similar routes, similar policies, and similar outcomes. As soon as the goal of central banks shifted from sustaining a global crisis to returning to price stability, it was reasonable to believe that both the FED and the ECB would have switched to a restrictive monetary policy. Operating in tandem, as they did previously. That is sort of what happened, but this time, structural differences between the two
economies would have rendered the decoupling of the two monetary policies inevitable. This is the base thesis upon which I based my bearish case scenario for EUR/USD.
As long as you print money at a rapid pace, you can expect similar outcomes, inflation. But when you switch to tightening, and Central banks have to raise interest rates and reduce their balance sheets, you have to consider other factors that can influence the policy. The United States and the EU have very different economies, structurally speaking. When you raise interest rates, you affect economic output, credit, exchange rates, financial markets, and so on. One of the greatest mistakes made by the markets recently, has been to disregard some crucial differences between the United States and Europe. By applying similar policies, it was expected to achieve similar results. Nothing could be further from the truth. And now the moment of realization is coming.
First of all, it is crucial to analyze the factors that have driven the recent moves in currencies. Speculative movements in exchange rates are influenced by many variables, but according to the specific situation, their weight may vary. Speculators are attracted by the highest total return that a currency may offer. The total rate of return comprehends the change in the exchange rate and the interest rate that the currency offers. Changes in interest rate differentials often influence expectations about exchange rates, thus driving moves in currencies, but the weight of their importance depends on the specific market environment. Other variables that it is important to consider are inflation expectations and the economic outlook because they are strictly related to the future level of interest rates.
The trade balance is another factor that should be considered. Usually, speculative transactions outweigh its influence in the short term, but it is still an important variable that relates to supply and demand for currencies. It is useful to check if the supply and demand of goods in a specific currency are working in the direction of speculation or against it. Changes in the trade balance may also influence the level of economic activity.
In this current market environment, it is safe to say that interest rate differentials have played a major role in currency movements. A recent example that confirms this hypothesis can be found in USD/JPY.
When the FED pivoted its monetary policy, one of the best trades to be made was long on USD/JPY. It was expected that the ECB would have followed the FED sooner or later, turning hawkish, while the Bank of Japan has been showing rigorous commitment to a dovish monetary stance. To this day the BoJ is still controlling the yield curve, and interest rates in Japan are close to zero, if not negative. Japan has historically been afflicted with deflation and has kept fighting it for 25 years. The BoJ seemed, and still seems determined to keep stimulating the economy through YCC. The two monetary policies were divergent, and the interest rate differential between the US and Japan was going to widen substantially. If you overlap the chart of the 10-year spread between the US and Japan and the USD/JPY chart, the similarity is undeniable. As soon as the FED started to raise rates, USD/JPY exploded to the upside.
It was easy for markets to interpret the situation in this case. That is why the correlation looks so clean.
This was just a recent textbook example of how interest rates have been influencing exchange rates in this current market environment. Expectations about interest rates have been a major driver in EUR/USD too. The problem is that the correlation is not as clear, because markets have had a hard time making up their minds on the matter and failed to take into account many variables.
The future course of interest rates, in this case, is strictly tied to the level of economic output and the future course of inflation. The course of events, linked to these two aspects, has been rather nebulous and markets might have misinterpreted it in the past year. They failed to recognize the influence of some important factors on the two economies, such as their post-pandemic outlook and fiscal policy, especially in Europe. In my analysis, I shall try to explain my point of view on all these topics and depict why I am bearish on the euro and long on the dollar.
Let’s dive deeper into EUR/USD’s recent story. The euro dropped below parity in September 2022. Halfway through 2021, markets started to discount a very aggressive hawkish FED. The FED started to raise rates convincingly, and the euro collapsed. In the meantime, inflation in Europe was running hot, while in the States, it started to cool down. The ECB then stepped on the gas. In October 2022, it started to cut its balance sheet and raise rates faster. The Euro started to recover. The USD depreciated against the euro for almost a year from that moment. At that point, a rebound was due, considering that EUR/USD went from 1.22 to 0.96. What I argue is that this consequent euro rally was based on false premises and brought the euro back into overvaluation.
This rally that brought the single currency back to 1.10-1.12 against the greenback was based on wrong assumptions and misinterpretations of the markets regarding the economic outlook for the US and especially for the EU. Thus the future course of interest rates and inflation.
I first developed my bearish thesis on EUR/USD in 2021, while the euro was trading around 1.20 on the dollar. The premises of my first view on the matter are still valid.
Firstly, I believed that the FED would have embarked on a tight monetary policy before the ECB, as the latter usually looks up to the former for guidance. Markets agreed with me on this.
But most importantly, I believed that the United States were in a much better position to handle such a hawkish cycle, compared to the EU. Specifically, I argued that the FED had more room to raise interest rates than the ECB, and the dollar would have ended up with a higher real interest rate. I believed that the EU’s economy was structurally much weaker than the US’, and it would have had a hard time dealing with an eventual credit contraction.
Additionally, I was skeptical about the ECB’s ability to tame inflation. If a recession was going to arrive, it would have hit Europe first and dealt a lot of damage.
Markets seemed not to agree with this. For some reason, throughout 2023, they have been discounting a higher probability of a recession in the US than in the EU. According to my opinion, this is nonsense. Now, reality is starting to unveil itself.
Source: Bloomberg, Apollo Chief Economist
First and foremost, I want to focus on the economic uncertainties of Europe, as they are probably the most important variable in my thesis and the most misinterpreted aspect by the markets.
The two major problems of the European economy are an outdated growth model that cannot keep up with global competition and, of course, sovereign debt.
The backbone of the European economy consists of small businesses. Of course, some European corporations and multinationals are present, but they are the exception rather than the rule. This was already a problem before COVID. Most countries were already struggling with weak competitiveness and low productivity. Competing in the marketplace with
American and Asian massive conglomerates became harder and harder for European companies. Small to medium enterprises suffer from a lack of funds for R&D, low wages, and low productivity levels. They are more subject to economic fluctuations, and it doesn’t take much of a decline in economic output to bring many small businesses down.
It is safe to say that the lockdown policy was devastating for the European economy. Closing down national economies was detrimental to small businesses, and many of them had to shut down for good. Politicians thought that with ever-lasting fiscal stimulus, they could have avoided any harm; they didn’t realize how hard they were punching in the face of the already weak economic environment they had been elected to manage.
An article by McKinsey and Co. came out in late 2020, which breaks down in detail the damage done by shutdowns to SMEs. Interestingly, loss of earnings growth aside, 1 out of 10 of the SMEs surveyed reported that they feared they could have filed for bankruptcy within the following six months.
Additionally, not only is Europe penalized by the structure and size of its businesses, but also the factors that determined its historical strengths have been endangered by the current economic trends.
Germany has historically been the major source of growth in the Eurozone. The whole continent has always counted on its economic output to stay afloat. Its strength comes from its powerful manufacturing industry and its export activity. Other countries have a similar growth model; Italy, for instance, relies on manufacturing and has historically run a trade surplus. France, to a lesser extent.
It can be seen that for a growth model based on manufacturing and export and an economic structure whose foundation is small-medium companies, which are already going through difficulties, an inflationary environment and consequent higher interest rates are absolute poison. The competitive position of Europe had already been deteriorating before COVID, then lockdowns were another huge hit, and now higher interest rates are battering what has remained. Companies are facing ever-increasing production costs, higher costs of money, and an appreciating currency that is making exports harder to do. Almost every country reported a deterioration in the trade balance. Not only is this point about supply and demand for the Euro, but it is also about economic output. The EU used to run a big trade surplus before the pandemic, which is now gone.
I believe that given these circumstances, an intense economic slowdown in Europe was inevitable after the ECB pivot. The war in Eastern Europe, which exploded in early 2022, added fuel to the fire and highlighted another important issue related to European policy, energy. The EU doesn’t have a harmonized energy policy, and every country member is mostly free to provide for itself. We can say that most members have always imported energy from abroad and rarely produced it on national soil, with the exception of France and its nuclear power plants. The Eurozone is a net energy importer. That makes the continent more sensitive to energy prices.
Russia had always been the biggest cheap gas provider for Europe. Germany and Italy had always relied on Gazprom. After the war began, this was no longer possible. Italy has not been affected much because the country sealed an agreement with Algeria, that eased the Russian gas fix. Germany, on the other hand, has not found a solution, and now its manufacturing industry is in the middle of one of the worst contractions it has ever experienced.
In any case, as a consequence of all the variables highlighted, the outlook for Europe would not be much different, even if the energy crisis had never materialized. Some of the biggest European economies are in the middle of severe contractions, even though they have been largely unaffected by the war. France and Italy, for instance. Germany would have experienced some sort of slowdown anyway, mostly due to lockdowns and higher interest rates. Needless to say, the shortage of energy in the country definitely affected its performance and added another issue to the already grim outlook.
If the energy crisis has definitely had an impact on manufacturing, a clear sign of broader underlying weakness can be found in services, whose numbers are plummeting too. This means that no sector has been spared, weakness has become endemic, and a recession starts to be a possibility. As previously explained, this is due to the uncompetitive position of
Europe, to bad policy choices and to the lack of structural reforms that were much needed and never arrived.
These are the EU’s latest PMIs, published in October, according to Bloomberg.
Eurozone GDP data confirmed these numbers, as the economy contracted 0.1% in Q3, while it was expected to stagnate.
In order to buffer such a loss in economic output, there are two routes. One would be to embark on structural reforms of the economy, which promote higher productivity, competition, a more flexible labor market, and so on. It is safe to say that the chances of structural reforms in the EU, at least in the short term, are close to zero. The Next Generation EU plan does not look promising because it will just provide countries with some fiscal aid, and as usual, they will not be pushed to make any serious structural change. The only other way to bring relief to economic data would be to have a weaker currency.
Another huge issue that needs to be addressed and taken into account in the EUR/USD analysis regards fiscal policy, specifically sovereign debt.
Sovereign debt, in certain European countries, runs at very dangerous levels, which are not sustainable. This is something that Europe has been dealing with for some time, yet no solution has been found. The trend of foreign investors fleeing from periphery debt and bond yields going up started decades ago and apparently culminated in 2011-2012. The peak of the crisis in the early 2010s was just apparent, as no long-term solution was really found, and the problem was just pushed under the carpet. The ECB committed to relentless bond buying, and Greece aside, the incriminated countries weren’t really forced to make any structural reform to bring their debt levels down. Allowing periphery countries to run such high debt-to-GDP ratios in such a low-growth environment was a very unwise move. In a market environment with rates near zero, QE, and low inflation, it can appear sustainable when in reality, it is not.
During the sovereign debt crisis of 2011, foreign investors started to doubt the ability of periphery countries to repay their obligations. Therefore, the European sovereign debt market began to be affected by large selling pressures, yields started to rise, and various treasury bonds were downgraded. The default scare grew big. Greece was almost forced out of the monetary union. The ECB came to the rescue, committing to large QE operations in order to bring yields down and to calm the markets. In the short term, this strategy worked. The problem is that largely indebted EU members weren’t forced to take any serious measures to bring their debt down and became largely dependent on the ECB’s QE. During the last decade, when inflation and rates were low, this problem should have been fixed, but it wasn’t. Now, the EU will pay the consequences.
With the Covid crisis, the growth and stability pact has been suspended, and most European countries have experienced a severe deterioration of their already gloomy fiscal position.
Most EU countries, including highly indebted ones, have been running huge deficits. Source: Eurostat
The ECB is currently facing a very serious dilemma. The central bank needs to restore price stability, hence raise interest rates, and cut its balance sheet, but at the same time, it has to make sure that periphery yields stay under control. Indeed, these two goals work in opposite directions, hence my serious concern about the ECB’s ability to successfully tame inflation. Raising rates in a low-growth, high-debt environment is a very delicate operation.
So far, the ECB has followed an ambiguous approach. It is letting German bunds on its balance sheet mature in size, and it is buying periphery debt through other instruments, such as the PEPP, which is now set to run until the end of 2024. In other words, the ECB hasn’t transitioned to a full QT stance, as it is still executing QE for a few specific countries.1 The PEPP portfolio has become a very important component of the central bank’s balance sheet.
This is clearly a precarious situation. Eliminating liquidity from the system will become progressively more difficult. Considering that the ECB has apparently paused its hiking campaign, the focus will shift to its balance sheet. It is hard to predict how this will turn out, but the outlook does not look promising, given these premises.
Through careful observation of yield movements, it becomes obvious that the ECB is manipulating spreads through the PEPP purchases; hence, some European treasury yields cannot be treated as a market price. Periphery yields do not offer any serious risk premium over German bunds, which are usually used as a reference. Italian, Spanish, and Greek 10-year yields appear too low. Investors can get equal, if not better, returns in the US or the UK debt markets, which are far more appealing.
Italy, the country that has arguably the least desirable fiscal position in the EU, is the clearest example of this manipulation. The movement of the btp-bund 10-year spread looks ambiguous, to say the least. It initially rose to 250bps, in the first half of 2022, as markets started to price in more hikes, but when the ECB stepped on the gas with rate increases, it started to fall. With rates rising overall, the Italian spread should have risen as the risk premium increases, also taking into account that the government has been running a very large budget deficit, larger than most other EU members. That did not happen; the spread dropped below 200bps. It has recently risen, as the market has been having doubts about the Italian most recent budget law and PEPP re-investments. As soon as President Lagarde confirmed that PEPP would go through until the end of next year, it dropped again below 200.
Another blatant indicator of this manipulation is the yield curve. It is a well-known fact that when market participants fear a recession, they pile into long-term debt and flee from short-term, thus inverting the yield curve. Considering the very aggressive tightening cycle that has taken place, the yield curve of most Western countries has been inverted in the past year, including the United States, the United Kingdom, Germany, and other European countries as well. That has not happened to Italy. What could possibly convince markets that Italy is going to dodge a recession while the US and Germany are not? There is no reason to justify this apart from the ECB artificially operating on the country’s bond yields.
The PEPP program does not focus exclusively on Italy; other periphery countries have been targeted with these purchases as well, such as Spain and Greece. With the ECB’s reference rate set at 4%, against the Federal funds rate of 5.5%, and periphery yields kept artificially low through PEPP, which is set to run until the end of 2024, the interest rate differential favors the dollar and will do so going forward.
If we look at what has been happening in the United States, the picture appears completely different. Markets have been eager to spot signs of a slowdown in the US, but economic data keeps surprising to the upside, surpassing even the most optimistic expectations. The economy expanded 2.1% in Q2 2023 and a staggering 4.9% in Q4.
As shown previously, markets priced in a higher chance of a recession in the US than in Europe, which was a completely misleading idea. For many reasons, the US enjoys bigger competitive advantages, and it was clear that its economic structure would have been less damaged by the current economic trends. The larger size of the American enterprises allowed them to navigate the lockdowns (which in any case were less restrictive than in Europe) with smaller drawdowns, and consumer spending remained a huge driver of growth, as very flexible wages have been rising in order to keep up with inflation. Unemployment still stands at all-time lows. Most importantly, technological innovations have been a huge tailwind that increased profits and attracted money and investors. The US is in the lead for what concerns the AI revolution, which is going to impact productivity meaningfully. Europe seems way less exposed to these new trends.
Additionally, America remains to this day a net energy exporter, thus making the economy less exposed to the negatives of higher oil prices in the short term, which could even put additional upward pressure on the dollar. As a result, Europe is more sensitive to the geopolitical turmoil that is ravaging the world right now.
Even though it was reasonable to believe that the US would have shown greater economic resilience, this kind of output is still very impressive. The Federal funds rate increased from 0 to 5.25%-5.5% in less than two years, and the economy has shown very modest cooling. As previously said, this has huge implications in terms of monetary policy, as clearly, the two economies are now experiencing different paths. It is unclear how much this American strength goes on, but as far as this EUR/USD trade goes, it is not strictly important, as it is obvious that Europe is going to be the worst performer overall going forward.
Consequently, a final point should be made about rate movements in the United States. As previously stated, the yield curve has been inverted for the past year; markets were expecting a recession and a premature end to inflation. The first cuts were expected as soon as 2023. Both expectations were completely off target. Markets kept shifting their expectations of rate cuts meeting after meeting, from June to the end of 2023.
Inflation data has indeed improved throughout the year, but price increases are far from being defeated. We are now at the beginning of Q4 2023, and CPI still stands at twice the FED target of 2%. Core PCE, the FED’s favorite price measure, ticked higher. This confirms that FED cuts have been priced in prematurely.
Latest CPI data. Source: Bloomberg.
Core PCE, the FED’s favorite inflation measure, ticked higher in October. Source: Bloomberg. Markets have started to understand that rates will stay higher for longer than expected, and as a consequence of very positive economic data, the yield curve has started to flatten, with the long end of the treasury leading the process. Higher rates on the long end will be a major driver of inflows into the dollar.
Another factor that should be noted regards fiscal policy. The US has seen a deterioration of its debt-to-GDP ratio as well, now standing around 120%. The government has been running large budget deficits, and with elections looming next year, both parties seem not concerned with stopping this fiscal vicious cycle. While it is true that this cannot go on indefinitely, it is
highly unlikely that this will change in the short term, considering not only American politics but also the very turbulent global scenario. Even though the US enjoys a very strong domestic demand, historical foreign treasury buyers, China and Japan seem less willing to sustain the American debt. Therefore, new debt issuance, paired with a restrictive monetary policy, will just add another reason for yields to go or stay higher.
To conclude, if the dollar keeps appreciating and the interest rate differential widening, the move into the greenback will just become irresistible.
As a consequence of the facts explored so far, it is reasonable to be bearish on EUR/USD. The EU is suffering from a serious economic slump, which can only be buffered by structural reforms or a weaker currency. The absence of risk premium on European yields drives investors out of the euro. Inflation still stands above the ECB’s target, and that puts the ECB in a tough spot, as raising rates has become more dangerous given the recessionary environment and the precarious fiscal situation. On the other hand, the United States has been showing far greater economic resilience. Consequently, interest rates can stay “higher for longer” more comfortably.
In the second half of 2021, the euro started to decline as markets started to price in a very hawkish FED, and that downtrend lasted until September 2022, when the single currency touched 0.96 on the dollar. From that point, the Euro started to recover and made an uptrend that lasted for a year, peaking in the 1.10-1.12 area. It is understandable that a rebound might have been due after such a prolonged drop, but in this instance, it was driven by completely off-target expectations regarding the economic outlook and future interest rates, and that overextended the move greatly. Markets have failed to consider many of the factors explored in this article and followed assumptions that reflected a misguided idea of reality. Speculative positioning has been greatly in favor of the euro, reaching an all-time high, and that brought the currency back up. Sooner or later, it was inevitable that reality would start to unveil itself.
This euro uptrend, which took place in the first half of 2023, was based on monetary policy expectations that did not make any sense. Firstly, markets expected the FED to cut as soon as the second half of 2023, which has already been debunked by reality. Data have shown a very modest cooling of the US economy. Cutting rates this soon would mean fueling inflation back up, thanks to the great amount of new money still in the system. The FED officials know this; they have learned the lesson from the 80s. Additionally, the American economy is showing unexpected strength, which makes cutting rates even more foolish.
Secondly, markets have interpreted the less encouraging European inflation data as a signal that the ECB was going to hike interest rates endlessly. There could be many reasons why the EU inflation has appeared stickier, one of them might be the issue related to sustaining periphery debt, which makes QT harder to do; another might be the higher sensitivity of the European economy to energy prices or also the fact that the ECB acted later than the FED. Anyway, stickier inflation might have boosted the Euro in the short term, but as the economy shrinks and price increases remain above target, it starts working in the opposite direction. Stagflation is the worst outcome for a currency. Anyway, as a consequence of all the uncertainties related to the EU’s economy, such as sluggish growth and a very difficult fiscal position, it was reasonable to believe that the ECB would have had a hard time raising rates. This view is still intact, as the ECB appears to be pausing its hiking cycle at 4% on deposits, periphery yields are lower than they should be to make sense as a purchase, inflation is still above target, and economic data are dismal. Additionally, the Eurozone remains highly dependent on energy prices and consequently on the current geopolitical turmoil, which could affect both economic output and inflation.
Essentially, the markets priced in a hawkish ECB, a dovish FED, and a weaker American economy, which had more chance of going into a recession than Europe. None of this made any sense. The amount of euro bullishness in speculative capital movements went through the roof and brought the euro back to 1.12. The truth has started to unfold in the past couple of months, and hedge funds have started to cut their long exposure on the Euro and their shorts on the greenback. The US treasury market has been selling off, as market participants have started to understand that rates are going to stay higher for longer than expected, and the yield curve started to normalize. The long end of the treasury, of course, has been leading the process. This will keep pushing the Dollar higher. It will probably put some pressure on the European rates too, but with PEPP investments continuing for more than a year, the ECB will probably keep yields under control, thus driving foreign investors out of the sovereign debt market and out of the euro.
This blatant mispricing of interest rate hikes and cuts drove the rally, and being based on false premises, it gave another great chance to investors to short EUR/USD at a good technical level.
It is worth concluding this excursus, outlining what scenario the future could be for the two major Western economies from a point of view focused on monetary policy.
As long as the two central banks keep monetary policy steady, it is clear that the greenback is going to have an advantage in terms of interest rate differential. However, most of the speculative capital movement in currencies, as in financial markets in general, is driven by expectations. Despite the evidence that economic data have presented, there could still be flawed expectations priced in terms of future monetary policy.
Markets are still clearly pricing in a more dovish FED, which is going to cut rates at the beginning of 2024, or even earlier. They are also pricing in a more hawkish ECB, with the first cuts expected for the summer. According to a Bloomberg survey, economists expect the first ECB cut in September 2024. Concerns about energy prices are what mostly fuels bets on further policy restrictions.
Source: Bloomberg survey of economists conducted Oct. 13-18
This narrative could be flawed. Recent economic data depicts a completely different scenario. Eurozone output contracted 0.1% in Q3, while it was expected to stagnate. Additionally, European inflation data has seen a significant improvement, with headline CPI touching 2.9% and energy prices falling considerably.
While it is impossible to be certain about which central bank is going to cut first, data is definitely not pointing at the FED. The Eurozone economy is shrinking, and the already weak growth forecasts might even be too optimistic. With this positive disinflationary trend, driven by falling energy prices, the ECB might be tempted to come to the rescue earlier than expected, given the very bleak outlook. On the other hand, the FED has seen a rebound in inflation numbers, as price increases in America are clearly more driven by consumer spending, and the economy is showing very robust growth despite the hiking cycle.
So, if monetary policy is set to be steady, the Dollar keeps its advantage over the euro. If we take into account the future course of rates policy, there is a chance that wrong expectations are still present, as economic trends are pointing to a different story than the one markets have believed so far. The ECB clearly has more reasons to embark on an eventual pivot.
The euro is currently trading in the 1.06 area on the Dollar, but it has room to fall. The single currency belongs below parity, and it will fall until it triggers some relief in the so far painful European economic data.
A huge mention to @RobinBrooksIIF, who, through his X account, has greatly raised awareness about the ambiguity of the PEPP reinvestments. His analysis of European yields and the Euro has been eye-opening.
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