Draghi knows what he's doing

Outlook:

The FT is calling it the "Draghi Effect" and headlines that the famous Deutsche Bank forecast of a weaker euro is now reversed. The FX strategist wrote "We are completely revising our euro outlook for the rest of the year. The speech is not the fundamental driver behind the change in view, but it aptly marks the culmination of a number of developments that have caused us to change our forecasts.

"We accordingly now expect the euro to rise to $1.16 or above by the end of the year (previous year-end forecast: $1.03). Our main message is that the euro is likely to be the key vehicle via which financial conditions in the Euro-area will be tightened. This could well mean that, like the Fed's exit, the ECB is unable to tighten as much as it thinks."

This is not quite a forecast of a taper tantrum, although others foresee something like it. Halpenny at MUFG says "Low volatility and calm market conditions breathes complacency and can result in out-sized moves relative to the fundamental explanation behind the move; perhaps yesterday's sharp move was more a reflection of positioning with market participants caught out." In other words, don't count on the Draghi Effect having a long shelf-life.

We agree with Deutsche Bank. For one thing, a breakout of this magnitude is hardly ever a just a blip. For another, Draghi knows exactly what he is doing. Yellen gave him what he needed with the "transitory" inflation thesis and weirdly, allows him to keep the upper hand over the Bundesbank, which simultaneously abhors inflation and QE in nearly equal measure. The BBK has been resisting QE all along and now Draghi is implying that the bank will be ignoring inflation trends temporarily in order to normalize. It's delicious.

While Draghi almost certainly doesn't want or seek a stronger euro, he can see a monthly chart like the one here. The euro has been downtrending since the 2008 crisis. Only in January this year we had a low of 1.0340. A rise to Deutsche Bank's 1.1600 is not that big a recovery. We get a reading of 1.2438 at the top of the linear regression channel and that would still leave the euro in a downtrend.

Weekly Chart

Monthly Chart

And Draghi is getting something else he wants—structural reform with fiscal implications. Granted, it's in France, and you can never count on the French voluntarily giving up any pinko gifts from the state. But Macron has proposed a new labor code and the cabinet has approved it. To avoid a Parliamentary vote, Macron is asking for authority to change the law by decree, yikes. The code will limit the horren-dous severance pay that prevents firms from firing workers and other changes to what is considered a rigid system. A change in the labor law will not solve the problem of French entrepreneurs moving en masse to London, but it's a start. France has just had the best six months for growth since 2010, accord-ing to Bloomberg, and consumer confidence is at the highest since 2007. That's momentum. Renzi is no doubt eyeing the situation with envy.

Another piece of news that may end up having a bigger effect than we now think is the EC admitting that Brexit will create a financing gap that must be filled some other way, affecting security, border control, anti-terrorism and defense. The FT writes that the UK's departure "blows a hole" in the EU budget. "While estimates vary because some spending commitments are multiyear, a report from the UK's House of Lords put the British contribution at 12 per cent." Can that number be right? For a un-ion containing 28 members, no single contributor should be paying 12%.

"The funding gap, and the possibility of a big political fight over how to fill it, is one of the main fac-tors behind the push from EU capitals for Britain to pay a hefty exit bill as part of its Brexit divorce." And the EC may be taking this opportunity to link financing to adherence to the rule of law, something Poland is declining to do in "respect the independence of the judiciary, media and civil rights," accord-ing to Reuters. Ah, federalism. Bottom line, the UK is not the only economy getting problems from Brexit.

Tidbit: Quartz reports US Agriculture Secretary Perdue is in China to restore US beef exports there after a mad-cow ban thirteen years ago, and in return, the US will take cooked Chinese chicken. This could be an epic fail if US consumers remember tainted dog food. We just discovered that Knox Gela-tin, formerly from Johnstown, NY, is now made in China. Ick. And at the same time, the US is consid-ering imposing a tariff on Chinese dumped steel and a little later, aluminum. It's not clear there is a trade war in there, but the common perception that all is well with China is probably not correct. Trump supposedly forgave China for failing to manage N. Korea. Really? Trump can hold a grudge longer than anyone.

Politics: The Senate leader had to postpone the healthcare/tax bill on a revolt in his own party over the public response to the bill. While voters are up in arms over the potential loss of government programs, there is no acceptance among Republican representatives that there is a social contract to provide essen-tial services. The opposition focus on the unfortunate is not a viable political strategy. The bleeding-heart approach won't work. It would be more effective to attack the insurance companies and Big Phar-ma. But, as usual, the Dems are muddling along and missing the opportunity. And while the Senate dithers, uncertainty rises about other programs that were supposed to boost growth.

Meanwhile, the president and UN representative are saber-rattling in the direction of Syria, but openly including Iran and Russia in the threat. Trump tells so many lies that it is hard to know when he might be telling the truth. And he is so inconsistent that it's hard to know when he might be changing policy from "stay out of stupid wars" to "bomb them back into the Stone Age."

Note to Readers: Next Tuesday is July 4, a national holiday in the US. All markets are closed and we will not publish any reports.

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