Markets Exaggerate, That is what They Do

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.