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2018-03-01Macro `n Cheese

How about that USD?

Roger takes a look at how capital flows can throw a spanner in the works for even the most robust of fundamental analyses, and leaves us with an FX-forecast of his own.

I have always looked at FX-analysts as the Kamikaze-pilots of the analytical forces. No matter how correct their fundamental analysis is, there always seem to be some weird capital flows occurring that wreak havoc on their conclusions. Hence, it is not without some angst that I enter currency discussions, especially since it is in the fundamentals vs flow nexus I found my inspiration for this week’s letter.

First of all, let us have a look at the weak dollar.

Macrobond Document
Figure 1: ….But “really” strong

Strange? – Anyhow, using the oft referenced Federal Reserve ‘major currencies’ exchange rate index, the USD is perhaps a tad weak, compared to its average, but only when looking at the nominal exchange rate index. Taking into account relative price developments, as in the real exchange rate index, the USD is actually quite strong, reflecting the higher (than elsewhere) inflation rates seen in the US over the past years. Hence, it turns out we need to make some distinction on what is puzzling to analysts when it comes to the “weak” dollar.

Of course, as the graph suggests, it could be as simple as a belated adjustment of a too strong real USD over the past years. However, apart from the fact that real exchange rate (indices) are hard to construct in an all-appealing manner, I think that what many analysts, including myself, have reacted to is perhaps not as much the level of the USD, but rather the weakening of the USD given the general outlook for the United States.

Macrobond Document
Figure 2: The US economy is still going strong

Even if the US is further into the expansion than most other economies, US data remain on the strong side and the FED’s monetary policy is being tightened at some pace. This stands in sharp contrast to the rest of the world; e.g., Europe where the ECB has yet to enact a de facto tightening of monetary policy. In an environment of strong growth prospects and increasing interest rate differentials between US and other economies, e.g. the Euro Area, we would instead expect the USD to strengthen, would we not?

So, why isn’t the USD stronger? – Despite the current state of economic conditions and monetary policy described above, current market commentaries suggest that USD-weakness is more a reflection of the strength in other major economies and, in particular, an effect of the European recovery. In the same way the USD strengthened in anticipation of FED tightening in 2014, the EUR has been strengthening in the hopes that the ECB will tighten sooner and more than what was previously expected1. This implies that a stronger EUR will (eventually) make the record-high Euro Area current account surpluses shrink again. At least that’s how the story goes.

1This line of reasoning seems to hold for other economies, e.g., Japan, as well. Macrobond Document
Figure 3: External trade is a central part of the Euro Area growth story

While it is true that Europe’s growth prospects are improving, my issue with this widely held view is that a central part of the European growth story is strong (net) exports. Between 2008 and late 2017 the USD strengthened on trend vis-à-vis the EUR, and the Euro Area’s current account balance rose in tandem. The recent strengthening of the EUR has been more moderate, and the improvement in the Euro Area current account has not reversed but decelerated. A continued, more pronounced, strengthening of the EUR would, nonetheless, put a dent in growth prospects, something that many ECB-members are also fretting about. What I am after is that expectations of actual tightening of European monetary conditions are perhaps getting ahead of themselves as a “really” weak EUR is instrumental for keeping a positive European growth outlook alive. Indeed, Mario Draghi recently reiterated that underlying cost pressures are low and that ECB policy will remain very supportive. This stands in sharp contrast to Jerome Powell who, if anything, suggested further hikes lay ahead.

In this era of inflated central bank balance sheets, and extreme liquidity, another way to illustrate my line of reasoning is to depart from the traditional balance of payment view where the current account is only a function of the relative macroeconomic conditions and to which the exchange rate and financial account respond in turn. If we instead take a step back and consider the possibility of the financial account – capital flows – pushing the exchange rate and current account ahead of it, I believe a more interesting narrative appears.

Macrobond Document
Figure 4: Something happened in 2015

Back in 2014, as the FED had tapered and ended its QE program on the back of a stronger US economy, it gradually became clear that the ECB was about to initiate a similar large-scale asset purchase program, the APP (asset purchase program) in response to a weakening of the Euro Area economies.

The ECB buying large amounts of (mainly government) bonds from the hands of private investors and pushing the refi-rate below zero, while US interest rates rose, created strong incentives for European investors2 to seek yield not only in more exotic EUR-denominated assets but also abroad in, among others, treasuries and US equities, leading the EUR “really” low (and USD “really” strong). This is apparent in the graph above where portfolio investment flows have poured out of the Euro Area and into, mainly, the United States. Do note, however, how European portfolio investment flows receded somewhat in 2017 compared to 2015 and 2016. Indeed, the pace of ECB asset purchases simultaneously decreased from some EUR 80 billion in the beginning of 2017 to EUR 30 billion currently, which in my topsy-turvy sort of BoP-analysis goes some way to explain why the EUR has been strong (and the USD weak).

Nonetheless, the very latest outcomes seem to indicate a rekindling of outflows. So, how does that coincide with my reasoning and the fact that the USD is still weak? Perhaps more importantly, what does it say about the future?

To consider developments during the past months, and in the near future, I think we must first add fiscal balances to our discussion.

2The same goes for foreign investors who have sold their EUR-denominated holdings for US and other, higher yielding, assets. Macrobond Document
Figure 5: Fiscal divergence

For a number of years, US fiscal balances have been virtually steady at -5% of GDP, while the current account (C/A) balance has been stable at around -2½% of GDP. This implies large external financing needs, but as the FED is now actively shrinking its balance sheet (and hiking rates), US private investors have to some extent redirected foreign holdings back into the US economy, filling some of the increased gap and allowing a (temporarily!) weak USD do the rest of the work.

Because, meanwhile, in the Euro Area, many countries have improved their fiscal balances dramatically and some are even posting surpluses now. As a whole, the Euro Area is currently close to achieving fiscal balance, which would be the strongest fiscal outcome since the inception of the common currency to date. As such, despite the “ECB-taper”, the QE-purchases handsomely outpace Euro Area governments’ new net issuance, which has created even more privately held excess liquidity. This liquidity has relentlessly started to search for yield in, among others, USD-denominated (safe) assets and in the process, of course (!), pushing the Euro Area current account balance upwards.

Macrobond Document
Figure 6:…Looks juicy to a safe asset starved, European investor

Looking ahead, it gets better/worse (depending on how you want to frame it). ECB continues to do QE and the Euro Area fiscal balances are expected to improve, while the Trump-administration’s economic policies have moved from a possible to an all but certain (and substantial) deterioration of fiscal balances, implying large and growing needs of external financing3. Should we take into account also the change in size and composition of foreign holdings of US assets, some analyses point to an even worse financing situation for the US economy.

Little wonder that US yields have been pushed upwards again offering yield pick-up for European investors. The recent see-saw changes in the interest rate spread between US and Germany (used as proxy for Euro Area) is clearly visible in the graph above and help to explain the more recent pick-up in European portfolio investment flows. Due to the very different financing conditions, this spread should continue to rise, and tighter US monetary conditions will continue to lure European investors into shifting EUR holdings for USD assets.

To conclude, current market commentaries have a hard time understanding the recent USD weakness and expect a stronger USD. Here, I have tried to lay out a more intuitive explanation for the USD weakness, a relative deterioration of the fiscal outlook. While this does not mean that the USD is now set to strengthen as a matter of course, it does imply that it is only when the ECB, de facto, alters course, shrinks its balance sheet – soaks up excess liquidity – and hikes rates, that a sustained EUR appreciation (and USD depreciation) will materialize.

When that happens, the eye-catching C/A-surpluses of the Euro Area will also come back down (and US C/A-balance improve), making many economists scratch their heads (again) as to how the causation really runs in traditional macro models.

There, my FX-forecast is out. All I have to do is brace for impact and expect to crash! – Until next week!

3And the FED continues to shrink its balance sheet and soak up ‘excess liquidity’.


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