Lagarde gives the euro some legs, but the rabbit hole is near – how central banks move currencies


The Europan Central Bank seems to allow the euro to rise while the Federal Reserve is staying lower for longer. Is everybody going Japanese? Valeria Bednarik, Joseph Trevisani, and Yohay Elam discuss how does the race to the bottom impacts currencies and what to look out for ahead of a busy week.

Yohay Elam: The European Central Bank has left its policy unchanged, but upgraded growth forecasts for 2020 and inflation for 2021. Most importantly for traders, ECB President Christine Lagarde said the bank is not targeting the exchange rate, only monitoring it. EUR/USD responded with a jump from around 1.1850 to the top 1.19. Do you think the common currency has more room to rise in response to the ECB?

Joseph Trevisani: I think market speculation that the ECB might seek to lower the euro was misplaced.

Valeria Bednarik: Well, it does, not only as a response to ECB but also responding to the now imbalance between the two central banks. The market is perceiving the Fed as dovish now. We will know more next week on that. But Powell made it clear that rates will remain forever low. This was clearly the most "hawkish" ECB we could get within a pandemic

Yohay Elam: Hawkish and ECB are words that usually don't go together

Joseph Trevisani: It seems the ECB and the Fed are determined to follow the BOJ down the rabbit hole of permanent zero rates.

Valeria Bednarik: Indeed... crazy year 2020!

Joseph Trevisani: If so, the rates will cease to be a determinant of currency values.  If everyone is zero then...? The problem of course is that zero rates do not promote economic growth, they produce stagnation.

Valeria Bednarik: Good question Joseph... will things change someday? One thing we should all agree with policymakers is the high levels of the infamous "uncertainty." We used that word for US-China tensions and Brexit, which are now jokes compared to the ongoing pandemic and the levels of precariousness we are seeing

Joseph Trevisani: Stagnation.   Zero rates are not the only problem with the Japanese economy, a declining population maybe even more detrimental, but the Europeans are fast approaching that condition as well. The biggest problem for zero rates is endgame. What are the conditions for resuming normal rates?  How will the financial system replace the pricing mechanism of interest rates if they are artificially induced?

Valeria Bednarik: How long will the world be ruled by the financial system? Will it prevail?

Yohay Elam: If everybody is dismissing inflation, at some point it will rise and so will rates. 2025?

Joseph Trevisani: Yes, our central bankers are suggesting that uncertainty is new.  That is preposterous.  Markets are specifically designed to handle uncertainty.  That is what they do, price uncertainty.  I have no confidence that the ECB and the Fed can do a better job of pricing the dreaded 'uncertainty" that markets.

Valeria Bednarik: Is not that easy as "everybody dismissing inflation."

Joseph Trevisani: Life is uncertain. It always has been, it will continue to be no matter what interest rates are mandated by central banks.

Valeria Bednarik: And as long as we have the same old same old faces in command... 

Yohay Elam: Life is uncertain, but many cannot stand it. That is why many incumbents win elections or are reappointed to head the central banks. Old faces in command as Val says

Joseph Trevisani: If you remove or greatly reduce the flexibility of the financial system to adjust through its main pricing mechanism, interest rates, in the long run, it becomes far more fragile, more dependant on central banks. That is a recipe for eventual disaster.

Valeria Bednarik: That's a good point. The deterioration is huge now, and normal turns obsolete. Still, I'm sounding apocalyptic and that's not the point. I don't think things will change in my life... or in my kids one. So we are back to when central banks would consider appropriate raise rates again

Joseph Trevisani: Yes, these are delusions of control.  To paraphrase Ian Malcolm from Jurassic Park...Disaster will find away.

Valeria Bednarik: I love Malcolm's view of life 

Yohay Elam: Humanity has been having a good run so far, assuming the dinosaurs are not coming back

Valeria Bednarik: What? You mean is time for a new species? A new species of politicians and policymakers, that's what we need 

Joseph Trevisani: More prosaically, Japan is the example that the Fed and the ECB refuse to heed. What is needed is courage and acceptance of limitations.

Yohay Elam: Japan is leading the way, not necessarily a good way...

Valeria Bednarik: Abenomics started in 2012 right? doesn't seem it works too good... As you said, not the best leading.

Yohay Elam: Japan skirted deflation. It is still a rich country, but the economy is stagnant

Joseph Trevisani: It managed to weaken the yen but little else and that did not revive the Japanese economy. But the yen at 78 to the dollar as it was in 2012 never made any economic sense.

Yohay Elam: A lot of drama at first, with Kuroda's QQE in the spring of 2013. Yet like every excitement, it disappeared later on

Valeria Bednarik: Yeah... shocks are what moves the market always. then, shocks become normal, and we wait for the next one.

Joseph Trevisani: Yes and the markets got the message and did much of the work for the BOJ.  but the basic Japanese problem remained. To be fair, the problems of the economy are far beyond the ability of the BOJ or any central bank to mend.

Yohay Elam: Monetary policy is not a panacea. Moving from the past to the near future. The Fed decides next week. On the one hand, it is dovish in the long term, allowing for inflation to overheat. However, some may see the Fed as hawkish in the short term, refraining from Yield Curve Control or negative rates. Do you think the Fed will move markets?

Valeria Bednarik: I doubt it. I see Powell as a measured conservative. Whatever he does, should not imply a shock. Unless an emergency. We are not on any emergency right now, at least no new one

Joseph Trevisani: No, the Fed has taken the middle path, implying lower rates for longer without taking any steps to enforce that policy. When an institution like the Fed makes a policy change it sticks with it. Consider. The ECB is undertaking an inflation policy review. It operates in the same world as the Fed, can its conclusion be any different? The concordance of global central bank policy, at least among the majors is approaching completion. In effect, it will largely remove rate policy from the currency arena.

Yohay Elam: So, we can expect the dollar to sail smoothly in response to the Fed? Perhaps US retail sales figures, published a few hours before the Fed, will steal the show

Valeria Bednarik: Unfortunately,  I have to agree. Speculative interest will look somewhere else. Retail Sales reaction may get delayed to post-Fed.

Joseph Trevisani: I don't think the Fed is going to emphasize the duration of zero rates but for the time being its policy is set and the ECB's is still under review...advantage euro. Agreed on the sales figures and economic statistics have more potential to affect markets.

Yohay Elam: The BOE also convenes next week

Valeria Bednarik: That will be much more fun than the Fed

Joseph Trevisani: Brexit is a lot more old fashioned.

Valeria Bednarik: But also a lot hotter 

Joseph Trevisani: Exactly. But much is the show. Like all the previous negotiations they will come to terms.

Valeria Bednarik: And at the end of the day, what we are looking for, is not who wins elections, or how high or low are the rates, but how all these events affect currencies

Yohay Elam: The BOE will probably join the ranks of the ECB and the Fed is leaning back and letting markets run – on the Brexit show. GBP volatility is providing opportunities to traders

Valeria Bednarik: Where would we be without BOJO...

Joseph Trevisani: I think so. The initial fear, that it would create economic disaster was largely a weapon used by the Remainers. The economic interest of both sides leans heavily to accommodation. The euro is back below 1.1900, I don't think Ms. Lagarde has given it legs.

Valeria Bednarik: Dollar neither has legs...

Joseph Trevisani: Haha yes, definite leg shortage.

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