It’s about growth - SocGen

Kit Juckes, Research Analyst at Societe Generale, notes that since the middle of 2014, there has been a slowdown in economic growth in the US and UK, partly due to cycles growing old in the tooth and economies running out of spare capacity (including labour) and partly because of the weakness of productivity.

Key Quotes

“Over the same period, there has been a clear acceleration in growth in Japan and the eurozone, partly due to the success of expansionary fiscal policies (Abenomics) and partly due to very accommodative monetary policies.”

“Now that we’ve seen the 3Q GDP data for these four countries/blocs, it seems sensible to start with that simple analysis because it’s what drives the central theme of FX markets. The two Anglo-Saxon economies are slowing and over time will likely continue to slow, and their currencies have probably seen their best levels. The US dollar is overvalued, and while the pound isn’t, the UK does have Brexit to keep the currency glued to the floor. The euro and yen are both undervalued and have scope to rise significantly. In the very short term, the euro has over-reacted in anticipation of early monetary policy normalisation, but it’s got a good way further to go over time. As for the yen, it looks set to be held down for longer because the government and BoJ take the 2% inflation target seriously, and it’s still way out of reach.”

“The pick-up in Europe/Japan is more interesting than the modest slowdown in US growth because our bearish dollar view owes less to expectations of slower US growth (for now) than it does to expectations that the recovery in Europe/Japan is here to stay. The US economy is slightly dull at the moment, with solid growth but decreasing slack and no sign yet of an upward trend in core inflation. This is reflected, in turn, in range-bound expectations about future Fed tightening.”

“I usually plot the DXY Index against TIPS, but here I’ve plotted 1-year rates in five years’ time against the Fed’s broad trade-weighted dollar as a rough guide to what the market expects for the terminal fed funds rate. In early 2016, this rate was falling as China, and then Brexit, hit confidence (and kept the Fed on hold). The dollar started to rally at the time of the UK referendum, which sparked concern about populism in Europe. Rate expectations surged with the arrival of President Trump, taking the dollar with them, but as hopes of easier fiscal policy have faded, rates have meandered in a range consistent, with the fed funds rate peaking at 2-2.75%.”

“The dollar de-coupled from Fed expectations at the time of the Sintra conference, when Mario Draghi discussed an early tapering of asset purchases, sending the euro sharply higher. That strength has been partially reversed on a re-think about the pace of ECB action, while US rates have meandered.”

“Relative trends in forward rates show why sterling suffered in 2H16 and why the dollar peaked in early 2017, drifted lower, bounced in September and is just beginning to look as though it is running out of steam. It needs the market to ramp up hopes of a terminal fed funds rate of 2.5% or higher if it’s going to keep its bounce going. Count me a sceptic.”

“In the very short term, CFTC data still suggest that the market is too long euros for the next move higher to start. And there’s no reason to look for US data to be negative for the dollar. But growth underpins the euro and the yen fundamentally. The BoJ is mandated to keep the yen down, but the ECB’s on the path to policy normalisation, and I can’t see why EUR/USD shouldn’t be at 1.30 within 12-18 months.”