A Look at the Consensus

 About two weeks ago, Bloomberg reported that “The stars are finally aligning for euro bears” – obviously, there was no such alignment in evidence hitherto. Although slightly dated, the article reflects the prevailing consensus. As we have prviously discussed in these pages, it is mainly a dollar-bullish consensus (83% dollar bulls in Merrill's July 2013 fund manager survey, a level high enough to indicate that a major trend in the opposite direction may get underway). Since the euro is by far the biggest weight in the dollar index, it is by inference a bearish consensus on the euro.

“Firms from Morgan Stanley to Bank of America Corp. that for almost a year called for weakness in the 18-nation currency, only to see it soar to the highest level since 2011, say they’re about to be vindicated.

Fresh evidence of lower demand for the region’s bonds, combined with a potential European Central Bank interest-rate cut in as soon as two weeks, are only serving to push the euro lower, they say. Looming European Parliament elections that may expose rifts over government austerity measures are also seen weighing on the currency.

“The change has finally started to take place,” Ian Stannard, head of European currency strategy at Morgan Stanley in London, said in a May 19 phone interview. “When we see easing measures, it’s not just the initial impact of a potential rate cut, it’s going to be the asset market performance to those easing measures which will be the key to the euro.”

Morgan Stanley predicts the common currency will tumble 12 percent to $1.20 by September 2015 from $1.3669 at 7:52 a.m. in New York. Bank of America sees it dropping to its 2013 low of $1.2746. The median estimate of about 90 economists and analysts is for the euro to end the year at $1.32.

The bears have reason to be optimistic. 

[…]

Nader Naeimi, who helps oversee more than A$30 billion ($27.8 billion) at AMP Capital Investors Ltd., said May 20 from Sydney that in the last two months he boosted his positions in trades that would profit from a lower euro. Selling the currency is “one of the highest-conviction positions,” he said.”

The article continues along these lines – several more fund managers and bank analysts are quoted, and they are all of one mind. The euro will go lower. This time for sure.

New UBS chairman and former BuBa president Axel Weber has also chimed in, via a recent editorial in the FT. Although the euro's exchange rate is only a side topic of his missive (his main concern is that financial market volatility is going to increase as a result of 'QE tapering' by the Fed), he stresses the divergent course of ECB and Fed policy in the context of the euro:

“Before long, these divergent fortunes are bound to lead to large differences in policy. In the US, interest rates could begin to rise in 2015. In Europe, they are likely to stay low for much longer. One might expect that movements in financial markets would reflect these expectations. However, so far, by and large, they have not. The dollar has been ailing for months, defying analysts' expectations that the currency would strengthen in anticipation of higher US interest rates. What is going on?

The answer is that market expectations seem to count less than current conditions, which still support the euro. First, the high yields on government debt in countries such as Italy and Spain have made them an attractive investment for believers in the ECB's pledge to do "whatever it takes" to save the euro. Second, America's shrinking pension deficits may have stoked appetite among pension-fund managers to lock in profits and match liabilities, helping suppress long-term bond yields. And then there are the central banks. The Eurosystem's balance sheet has been shrinking for more than a year, as banks that borrowed from the central bank under the longer-term refinancing operation (LTRO) have repaid their debts early. Meanwhile, the Fed's balance sheet is still growing, albeit at a reduced rate.

However, these factors are temporary. LTRO repayments are coming to an end, US quantitative easing will be completed by the end of the year, five-year government bond yields in Spain are already similar to those in America and long-dated US government bond yields are pricing in unrealistically low expectations of future economic growth. Diverging monetary policy will soon begin to have more impact.”

 In other words: the stars are aligning for euro bears. But are they really?

The euro against the dollar, daily, with lateral support and resistance levels. On a purely technical basis, there is not yet a good reason to become overly bearish – click to enlarge.

Speculators as a group have quickly turned bearish on the euro again in the wake of its recent correction (which was triggered by Mario Draghi promising 'action in June' – i.e., this week). They are once again net short the euro. It must be pointed out though that their position could become still larger. What strikes us as noteworthy is only how quickly they have adopted a net negative view again after the euro has proved unexpectedly strong for so many months:

Speculators turn net short euro futures again, after briefly flirting with a small net long position. Their positioning history in the euro is mixed in terms of its predictive qualities, but it is still remarkable that negative sentiment has returned so quickly – click to enlarge.

Normally would mock the fact that apparently 'everybody knows' now that the euro will fall, but we have become a bit wary after the yen's decline in the face of an even stronger consensus. If the ECB is very vocal about wanting to weaken the currency, it may at least for a while be successful as well, based on perceptions alone.

The ECB and the Fundamental Backdrop

 Below is a chart showing the consensus on what new policy measures the ECB will most likely announce this week. This is not necessarily a contrary indicator in the sense that something else is likely to happen. It only tells us that certain expectations should by now be 'baked into the cake', i.e., the euro's exchange rate likely already reflects them.

Via Nomura: what will the ECB announce at the June meeting? - click to enlarge.

We would say that a cut in the refi rate and a cut of the deposit rate into negative territory are indeed quite likely at this stage. Neither is likely to accomplish anything, not even from the point of view of those who believe the ECB should in fact attempt to stoke inflation.

Lifting the sterilization of the SMP strikes us as a possible surprise measure, as it is already known that the BuBa won't object to it (whereas outright 'QE' still remains opposed by Weidmann & Co. at the current juncture). It is difficult to see why that would not amount to 'monetary financing of fiscal debt', but for some reason the BuBa has dropped its misgivings about this particular idea. Should this measure be taken, it would certainly surprise the markets and may lead to more selling in the euro in the short term. However, if no such surprise occurs, the probability that the euro will actually strengthen is likely just as high as the probability that it will weaken in the wake of the ECB's rate decision.

Many people erroneously hold that exchange rates are driven by relative economic performance. This is definitely not the case. In the long run, the decisive factor is ceteris paribus how quickly the supply of a currency is increased relative to the supply of other currencies. In the short run, expectations about central bank policy and interest-rate differentials may predominate as drivers. In the medium term, a trade surplus tends to exert a slightly supportive effect, as countries with a surplus are less reliant on foreign capital inflows.

US true money supply growth (TMS-2) continues to exceed euro area money supply growth by a considerable margin (8.22% vs. 5.5.% y/y; the growth rate is currently declining in both currency areas). More importantly though, while the euro area's money supply is up by approximately 46% since early 2008, it has increased by about 94% in the US. The lagged effects of this explosive money supply growth continue to percolate through the economic system, leading to distortions in relative prices (and the associated misallocation of scarce capital), a redistribution of real wealth from late to early receivers of newly created money (essentially from the poor to the rich), and an asset price bubble in stocks and low grade bonds that mirrors said capital misallocation.

All these trends will reverse once the rate of change in money supply inflation falls below an unknowable threshold (in the past, the range of 3% to 5% y/y  has been important in the US in this context, but obviously there is no fixed magnitude; which level will prove decisive this time around depends on contingent circumstances). Will the Yellen Fed continue to tighten if, or rather when, asset prices begin to decline precipitously? That seems highly unlikely. Therefore, the assumption that US and euro area monetary policy will drift apart for a lengthy period of time may turn out to be mistaken.

Euro area money TMS (currency plus sight deposits) and its annual rate of change (blue line). From high double digit rates during the bubble era to mid single digits today - click to enlarge.

With regard to the euro-dollar exchange rate,  the longer term effect of the above mentioned large difference in money supply growth probably shouldn't be underestimated.

Moreover, the euro area's banking system by and large remains in worse shape than the US banking system and is therefore unlikely to increase its inflationary lending. More importantly, private sector credit demand has plunged as well (the ratio of new borrowing to every euro in GDP growth has declined to about 0.3 from 1.1.).

It could well be that the euro area is on a path that is very similar to Japan's in this regard – the central bank's attempts to inflate continue to be thwarted by the fact that one can lead the horse to water, but one cannot make it drink. This argues for a stronger euro, regardless of how the economy is doing. Note in this context that the yen's strength since 1989 has also been largely independent of the economy's performance – in fact, economic weakness, by affecting the rate of credit expansion, has contributed to yen strength rather than weakness.

Bank lending to non-financial corporations in the euro area continues to contract. Contrary to conventional wisdom, we believe that this is a salutary development, as it means fresh capital malinvestment is likely to be held in check. Who wants a repetition of the egregious bubble that burst so spectacularly in 2008 and led to the biggest economic crisis of the post-war era? Note that there is nothing wrong with credit growth as such. It is inflationary lending – the creation of new deposit money ex nihilo – that is problematic – click to enlarge.

Expectations about the euro's future purchasing power are also an important factor, since they influence the price premium embedded in market interest rates. The originary interest rate can never disappear or turn negative – as Mises has pointed out, it is  “a category of human action that is operative in any valuation of external things”. Someone with zero or negative time preference would never consume. Obviously, such people would very soon die – it is an unthinkable condition (exceptions to this may be cases of mental illness or hunger strikes by prisoners).

'Inflation expectations' as reflected by the price premium built into market interest rates in turn influence the level of real interest rates. With the euro area's HICP (harmonized index of consumer prices) at only 0.5% recently and expectations that price increases will continue to be subdued or decline further widespread, low nominal administered rates are higher than they appear in real terms. This is potentially bullish for the euro.

Euro area HICP – currently it is at 0.5%. This 'harmonized' rate masks considerable differences between euro area member nations. In some places like Greece, consumer prices are reportedly actually declining –  probably to the great relief of many Greek citizens. In other countries like Germany and Austria, they are rising at a rate close to the ECB's 2% 'target inflation rate'. Mind, we are ignoring for the moment that there is no such thing as a 'measurable general price level' - click to enlarge.

Of course Europe's bien pensants want to change this happy state of affairs, in the misguided belief that a higher rate of 'price inflation' will somehow enhance economic prosperity. However, their misguided dogma notwithstanding, it will be difficult to get inflation going in the euro area, unless the ECB alters its modus operandi in ways the BuBa presumably continues to frown upon. 

Pursuing the economic doctrines of John Law and other inflationists still runs into the obstacles created by the ECB's statutes, although we have no doubt that if the men at the BuBa were to give their placet, the ECB's board would have no problem in reinterpreting said statutes to mean whatever it wants them to mean.

Lastly, it seems that employment of the US dollar in international trade and as a reserve currency is set to decline somewhat in coming years. There are two major reasons for this: a) the US trade deficit is shrinking, mainly due to weak consumer demand and rising domestic oil production and b) a number of EM countries, chiefly among them China and Russia, are trying to reduce the dollar's importance in trade by striking bilateral agreements with trading partners that aim at reducing the dollar's role as a transaction currency. Whatever the wisdom of such policies may be, they are being implemented. This is bound to affect the dollar's exchange rate at the margin, as the demand to hold dollars will decline. We don't want to exaggerate the importance of this development; in the near to medium term it is unlikely to have much of an effect. Longer term it could however put some pressure on the dollar.

Conclusion

If the ECB clearly signals that it wants the euro to weaken further, whether by word or by deed, more short term weakness in the euro could be in store. However, in the medium to longer term – barring a return of the sovereign debt crisis in the euro area – it seems there are more reasons to expect the euro  to strengthen rather than weaken. The main reasons are that the central bank is finding it difficult to boost the money supply in the face of an ongoing decline in private sector credit outstanding, and the associated decline in inflation expectations. These factors are more important as long term drivers of the currency's exchange rate than relative economic growth rates. In short, there is a chance that the euro could become the 'new yen'.

Charts by: ECB, sentimentrader, Nomura, stockcharts