Divergent policy wins

Outlook:

It should be a slow day today—it’s the Veterans Day holiday in the US. Banks and the post office are closed and the bond market is closed, although the stock market remains open. This gives us time to consider fresh ways of looking at things, like the newly-minted “two-tier” Chinese economy. Or to discard trying to bend our minds around new stuff that probably doesn’t count. Emerging markets always behave this way and it never fails to scare observers. To be fair, some first EM surges of growth do falter and never come back. Argentina has done it numerous times.

Yields count in FX, or rather relative yields. The US is getting what looks like more than a temporary spike in the 10-year (and the 2-year, too). Yesterday the high yield was 2.377%, inspiring the Market News fixed income chart-reader to expect a test of the July 21 high at 2.403%.

Meanwhile, the Bund is getting softer by the day. It put in a weird high print on Monday at 0.72%, but retreated back to the 0.60% level and is expected to go lower to sub-0.60%, depending on what the ECB says and does about QE. Market News reminds us that “… at the peak of U.S. and German bond selling seen in late June, 10-year U.S. yields saw a high of 2.50% June 11 and 10-year Bunds a high near 1.056% June 10.” That gave us a differential of 144 points, whereas now it’s 173 points.

The rise in the yield differential favors the dollar. The important point is that nobody sees a reason for the US yield to dip back or the Bund yield to rise. Even if the Bund stays steady around 0.60%, the US “should” be creeping back toward 3%, widening the differential. We have long held that the differential has to be 250 bp or more to solidify the dollar rally. It’s the premium the US has to pay to make up for not having a balanced budget rule, or a clear-talking Fed, or a trust-worthy legislature. In other words, the dollar is starting to get real, justifiable support and perhaps escaping the long-stranding bias against it. That’s if the US doesn’t shoot itself in the foot in some way.

Euro bulls are having a hard time accepting that the policy divergence is having the inevitable currency market outcome. In the FT today, some analysts tie themselves in knots trying to find a reason for the euro to stop falling. “The decline in the euro could easily eat its own tail, in a twist of logic that's bug-ging currency watchers… [the euro is the weakest since April]. The problem: The euro is falling partly because the dollar is climbing, and partly because traders and investors believe the European Central Bank is set to do more easing in December. And yet the more the euro falls, the less need there is for the ECB to do that, as the weaker currency should support inflation.

“Meanwhile, the dollar is climbing because, in contrast, the market expects the US Federal Reserve to raise rates in December. At the margins, that's likely to put the Fed off. More importantly, as former ECB official Lorenzo Bini Smaghi wrote in the FT yesterday, the heavy lifting by the Fed and the dollar does take the pressure off the ECB to follow through.”

Oh, please. This assumes the two central banks are placing currency levels at the top of the priority and factor list. This is unlikely in the extreme. The ECB probably looks at the euro level more than the Fed looks at the dollar, but in both cases, the chief aim is institutional—bank lending, capital investment, overall growth and thus inflation. Surely the ECB shrugs off whatever inflation comes in through the import door. It’s a mechanical effect, not an organic one.

Two important analysts (at Citi and SocGen) fret that the ECB could retreat from raising stimulus because of the weak euro, which gives them what they want without effort. If the ECB pulls back from hints it will become more aggressive in December, the euro shorts would unload their positions very fast. And those positions are big. The euro could rally like a banshee. Well, yes, that’s how markets behave, but it’s not how central banks behave.

We are not exactly a perma-bear on the dollar, but always skeptical. This comes from hard experience and eating a lot of crow. Still, we think Viscco and Draghi are telling the truth, the whole truth and nothing but the truth. The likelihood of the ECB pulling back from the more aggressive plan in December is very low. The likelihood of the Fed daring to delay again in December is also very low. We can see the future for once. The only question is whether the currency effect is already fully priced in. Based on recent experience, the answer is no. Other dollar perma-bears have yet to buy into the divergent policy scenario. Hmm, that means the euro rout has a way to run still.