Uncertainty threatens Euro’s safe-haven status, for now
The Euro Nominal Effective Exchange Rate (NEER) appreciated about 8% between 20th April and late-August and outperformed all major currencies. However, since its multi-year high on 28th August the Euro NEER has weakened an albeit very modest 1%.
The question is whether/when the Euro may again find favour and set new multi-year highs or whether a more acute correction looms.
Part of the answer lies in the confluence of inter-related factors which contributed to the Euro’s steady climb in the first place but have recently lost some traction.
Prior to its take-off in April, the Eurozone NEER had been one of the more stable among the majors. The Euro was perceived as neither a “risk-on” nor “risk-off” currency and the ECB tacitly welcomed the Euro’s underperformance versus its key trading partners’ currencies.
While the French presidential election in April-May was an important catalyst for the Euro’s appreciation, the seeds for its rally and accession to “safe-haven” status had arguably been sown in 2015-2016.
However, some of these Euro-positive factors have become prey to far greater uncertainty and lost traction in recent weeks, undermining the Euro’s relative appeal while the Dollar and Sterling narrative has improved somewhat.
Financial markets have in particular reacted negatively to Sunday’s German federal election and uncertainty it has generated, both at a domestic and European level.
The Euro finds itself at a cross-road and I see little scope for rapid and/or sustained appreciation until the ECB announces the modalities of an extended QE program and a new German government is in place, with the risk biased towards bouts of Euro weakness.
Longer-term, however, a number of factors could drive renewed Euro appreciation, albeit at a likely slower pace than in April-August.
Euro’s impressive rally has run into headwinds in past month
The Euro Nominal Effective Exchange Rate (NEER) appreciated about 8% between 20th April (i.e. just before the first round of the French Presidential elections on 23rd April) and late-August and outperformed all major currencies according to my estimates (see Figure 1). Year-to-date it is up 5.8%, in close second place behind the Czech Crown NEER (+6.2%).
However, since its multi-year high on 28th August the Euro NEER has weakened an albeit very modest 1% (see Figure 2).
While it has appreciated against a number of Asian currencies, it has weakened against a resurgent Dollar and in particular Sterling (see Figure 3).
With financial markets eyeing a congested Q4 macro-data release and event calendar (see Figure 1 in Asymmetric data and event risk, 22 September 2017) the question is whether and when the Euro may again find favour and set new multi-year highs or whether a more acute correction towards the middle of even lower-half of its multi-year range looms. Part of the answer, in my view, lies in the confluence of inter-related factors which contributed to the Euro’s steady climb in the first place but have lost some traction in recent weeks.
Phase I – Euro NEER remarkably stable prior to its April take-off
Prior to its take-off in April, the Eurozone NEER had been one of the more stable among the majors (see Figure 4). While individual Euro currency crosses have been volatile or trended for long periods of time, against a GDP-weighted basket of its trading partners’ currencies the Euro had been remarkably stable since 2010.
Figure 5 shows that between 23 April 2010 and 20 April 2017, the Euro NEER traded in a narrow 16% range, compared to 29% for Sterling, 40% for the Dollar, 44% for the Swiss Franc and 55% for the Yen. Only the Singapore Dollar NEER – which the Monetary Authority of Singapore actively manages – and the Danish Krone – which is pegged to the Euro – traded in narrower ranges. The Euro NEER was particularly stable in the 14 months prior 20 April 2017, trading in a 4%-wide range according to my estimates.
The Euro was not even close to enjoying high-yielding status as a result of the European Central Bank’s (ECB) successive policy rate cuts and launch of a Quantitative Easing (QE) program in January 2015 (see ECB wins first battle but long war ahead, 23 January 2015). At the same time, unlike the Yen and Swiss Franc it did not enjoy safe-haven status due to tepid Eurozone economic growth and the threat to financial stability posed by Greece’s collapse in 2013-2015 (see Greece lightening, 28 January 2015) and shaky Italian banking sector in late-2016 (see Renzi referendum frenzy – Storm in a brittle tea cup, 2 December 2016).
Moreover, the omnipresent rise of nationalist and populist parties was brought to life by the United Kingdom Independence Party’s strong showing in the British general elections in May 2015 (see UKIP has what every political party wants…momentum, 30 November 2014) and crystalised by the “leave” vote in the referendum on EU membership in June 2016 (see Post referendum circular reference, 7 July 2016). This growing challenge to mainstream policies was seen as a serious risk to the cohesiveness and future of both the Eurozone and EU-block.
Put differently, the Euro was perceived as neither a “risk-on” nor “risk-off” currency and the ECB tacitly welcomed the Euro’s underperformance versus its key trading partners’ currencies, including the Dollar, Sterling and Chinese Renminbi (see Figure 4).
Phase II – Lagged QE impact and receding nationalism drive Euro appreciation
While the French presidential election in April-May was an important catalyst for the Euro’s appreciation, the seeds for its rally and accession to “safe-haven” status had arguably been sown in 2015-2016.
The ECB only launched its QE program in January 2015, a full six years after the Federal Reserve (Fed) and Bank of England (BoE) started their first rounds of asset purchases in respectively November 2008 and March 2009 (see Figure 6 and European Central Bank QE: A little late to the party, 8 January 2015). While QE can boost asset prices in the short-run, its impact on underlying economic growth is typically far less immediate. This partly explains why economic activity in the Eurozone, as measured by GDP growth, lagged other developed economies’ prior to 2016 but has caught up in the past 18 months (see Figure 7).
Moreover, the Eurozone was in a good position to benefit from the ongoing up-tick in global GDP growth and demand (see Figure 8) thanks in part to a reasonably cheap Euro (see Figure 4) and competitive exports of goods and services. In particular growth in the Euro-value of German merchandise tripled to 5.3% in the past 12 months from 1.8% in the preceding 12 months (see Figure 9).
The Troika had also by the summer of 2015 drawn a line, even if blurred and potentially temporary, under the increasingly pressing issue of whether Greece would default and potentially leave the Eurozone (see Greece – Copout still more likely than bailout or burnout, 7 July 2015). Moreover, the ECB’s purchases of Eurozone member states’ government and corporate bonds as of early 2015 had twin, related benefits. In a first instance they put a floor under the demand for bonds, which was particularly valuable to poorer and highly indebted countries such as Greece. This in turn depressed yields and interest payments for member states under pressure to keep their fiscal deficits under 3% of GDP.
At the same time the economic and political narrative in the US and UK was turning against the Dollar and Sterling. The British electorate’s vote in favour of “leave” at the June 2016 EU referendum and Donald Trump’s victory in the November 2016 US presidential elections introduced a great degree of policy uncertainty. This in turn contributed in the UK to a sharp slowdown in GDP growth in H1 2017, with higher headline inflation lifting import costs and biting into consumer demand and fixed investment adding little to overall growth (see UK: Land of hope & glory…but mostly confusion, 7 July 2017). Policy uncertainty, modest GDP growth and still low underlying inflation in turn contributed to the Fed’s very conservative 50bp of hikes in H1 and pause at its September meeting and the BoE’s emergency 25bp rate cut in August 2016.
Finally and importantly, the cloud hanging over the Eurozone and EU in the form of increasingly powerful nationalist parties with anti-European agendas was partly lifted by Austrian Presidential elections in December 2016 and Dutch legislative elections in March 2017. Nationalist parties and candidates under-performed and ultimately remained outside of power, in line with my expectations that markets had over-estimated these parties’ appeal and reach (see Nationalism, French presidential elections and the euro, 18 November 2016).
But it was elections in France – the EU’s second largest economy – which provided the spark for a Euro rally which lasted a full five months and cemented the Euro’s status as a safe-haven currency in my view (see French politics, UK macro data and possible GBP/EUR downside, 21 April 2017). Indeed Figure 10 suggests that narrowing Eurozone government bond yield spreads – proxied by the gap between 2-year US Treasuries and German Bunds – have supported the EUR/USD cross by reducing the risk of credit defaults in the Eurozone, lowering member states’ financing costs and driving Eurozone economic activity. In the previous 12 months, the narrowing yield spread had worked against the Euro with higher relative yields in the US (in a low-yielding world) making the Dollar more attractive versus the Euro.
The convincing victory of centrist and pro-Europe candidate Emmanuel Macron over National Front leader Marine Le Pen in the Presidential elections and his party’s clear majority in the legislative elections seemingly banished the prospect of a far right candidate and party toppling the established order and poured cold water on the prospect of other EU members states following the UK’s lead in leaving the EU (see 2017 French elections – They think it’s all over…it isn’t, 11 May 2017).
Euro running into multiple economic, policy and political headwinds
However, some of these Euro-positive factors have become prey to far greater uncertainty and lost traction in recent weeks, undermining the Euro’s relative appeal as a cheap, safe-haven currency. At the same time, the Dollar and Sterling narrative has improved somewhat.
1. Valuations and profit-taking
At the risk of stating the obvious, with the Euro NEER still only 1% away from its multi-year high the Euro is not as attractive from a valuation perspective as it was in April when the Euro was broadly in the middle of its long-term 16%-wide range (see Figure 4). Perhaps unsurprisingly, some fund managers and traders have seemingly reduced or closed out long-Euro positions to lock in profits ahead of Q4.
2. Trump and Brexit
There is little doubt that messy internal White House politics and President Trump’s inability to push policies through Congress (despite a Republican majority) and the looming exit of the UK from the EU in March 2019 are dark clouds over US and UK economies still beset by structural weaknesses including tepid productivity and wage growth (see The common theme of low-wage growth, 10 February 2017). However, there are glimmers of hope. After months of procrastination, the US administration has finally put forward the outlines of a comprehensive tax-cut plan (see Appetite for destruction… and procrastination, 8 September 2017).
In the UK, Prime Theresa May’s government has at long last conceded to an interim deal with the EU to avoid a cliff-edge once the UK officially leaves the EU in 21 months time, in line with my expectations (see When two tribes go to war, 2 June 2017). While there is still much disagreement within the cabinet about the modalities of such a transition period, the EU has given an admittedly tentative thumbs up to the two-year transition detailed in Theresa May’s recent Florence speech.
3. Central bank monetary policy
The US and British governments have thus given markets and central bankers some crumbs of comfort that policy progress is possible (even if slow and tentative), while US and to a lesser extent UK macro data have improved slightly in recent months. This has arguably helped the Fed and BoE steel the march on the ECB in signalling their hawkish policy intentions.
Both the Fed and BoE made clear at their recent policy meetings that they are inclined to hike their policy rates 25bp in Q4 2017, despite low underlying inflation in the US and UK still posing somewhat of a dilemma (see Asymmetric data and event risk, 22 September 2017). Barring a major downturn in domestic and global growth and/or geopolitical event, the Fed will likely deliver its third hike of the year while the BoE will reverse the August 2016 rate hike and take its policy rate back to 50bp. Markets have almost fully priced in this arguably quite abrupt hawkish turn by the Fed and BoE, with higher Treasury and Gilt yields providing, respectively, Dollar and Sterling support.
Conversely, the ECB has tried to gently talk down the Euro and has yet to confirm long-standing market expectations that it will extend its current QE program into 2018 and possibly 2019 while likely reducing monthly asset purchases from €60bn. While it is debatable whether such an announcement, possibly at the ECB’s 26th October meeting, would have a material and/or lasting impact on the Euro’s fortunes, financial markets arguably do not tend to respond well to prolonged uncertainty.
4. German elections
Financial markets have reacted negatively to Sunday’s German federal election and the political and policy uncertainty it has generated, both at a domestic and European level.
Chancellor Merkel’s centre-right Christian Democratic Union (CDU) party and its Bavarian sister-party, the Christian Social Union (CSU), again won the most seats (246) in the Bundestag (see Figure 11). As a result Merkel is likely to have secured her fourth consecutive four-year term as Chancellor. But this was the worst federal election outcome in almost 70 years for the CDU/CSU alliance (see Figure 13) which fell well short of a 355-seat majority in a more divided and unprecedented six-party parliament, in line with my expectations (see Paradox of acute uncertainty and strong consensus views, 3 January 2017).
Merkel’s uneasy victory leaves options (and delays) on the table
The CDU/CSU alliance, which is 109 seats short of a majority, has ruled out a coalition with the far-right AfD (94 seats) and is unlikely to consider teaming up with the Left-Party (69 seats). This in effect leaves it with four possible options, in my view, but none of these scenarios are particularly appealing for the CDU/CSU and the risk is of protracted negotiations lasting weeks or possibly months.
Option 1 – Another 4-year CDU/CSU and SPD coalition
The CDU/CSU could extend the current majority coalition with the centre-left Social Democratic Party (SPD) which won 153 seats. Such a coalition, which has been in place in 8 of the past 12 years, would have a comfortable 44-seat majority but the SPD, which arguably fared badly in the outgoing government, seems reluctant to sign up to another four-year term alongside the CDU/CSU. A number of senior SPD officials have expressed a preference for a rainbow coalition which would include the SPD, the Free Democratic Party (FDP), Greens and Left-Party and would have a slim majority of 14 seats.
Option 2 – A largely untested Jamaica coalition
The CDU/CSU could opt for a three-way majority coalition with the FDP, which won 80 seats, and the Greens which won 67 seats – dubbed the “Jamaica coalition”. The CDU/CSU ruled alongside the FDP in 2009-2013 (before the FDP lost all its seats in the 2013 elections – see Figure 13) and a tripartite CDU/CSU, FDP and Green coalition exists at a state level. But this coalition is untested at a federal level and the laissez-faire FDP and interventionist Greens disagree on a number of key issues, including the direction and future of the EU, immigration and the environment (see Asymmetric data and event risk, 22 September 2017).
Moreover, the FDP has made its support conditional on securing the Finance Ministry position which CDU member Wolfgang Schauble recently vacated to become Bundestag speaker. This is unlikely to sit well with Merkel who has historically kept a tight leash on economic and financial affairs.
Option 3 – The novelty of a minority government
The CDU/CSU could opt to form a minority coalition with the FDP or Greens and seek parliamentary support from other parties on a case-by-case basis, on the premise that the SPD would find it even harder, with only 153 seats, to form a majority coalition. But this is an option which Merkel has shunned in the past and the experience of the minority Conservative Party in the UK – forced into an unlikely alliance with the Northern-Irish DUP – is unlikely to have sold Merkel the merits of a minority government.
Option 4 – Call another set of federal elections
If negotiations lead to nowhere in coming weeks, as a result for example of Merkel being unwilling to meet potential coalition partners’ demands, she could look to trigger another set of federal elections. But there is no guarantee that the CDU/CSU would win more seats second time round, with the risk of the CDU/CSU further alienating the electorate and gaining even fewer seats.
Financial markets quietly concerned about split parliament and far-right’s rise.
I would expect a negative reaction to the more unlikely scenarios three and four and see a risk of a Euro wobble in the event of the CDU/CSU forming a Jamaica coalition. Merkel would potentially come under pressure from the FDP to rein back any further integration of the Eurozone and EU, which could set Germany on a collision course with French President Emmanuel Macron who is pushing for a more federalist Europe (including a joint EU budget, finance minister and military taskforce). At the same time the Greens would likely make their support conditional on a loosening of German fiscal policy – a line in the sand which Merkel has refused to cross in the past.
A CDU/CSU alliance with the SPD would probably be the most benign from a market perspective but would not be without its challenges. The SPD contends that it was weakened by its ruling alliance with the CDU/CSU and it would likely make it support conditional on securing key ministries and a more interventionist economic agenda. This would in turn raise questions about Merkel’s ability to run a tight fiscal ship and her credibility as Europe’s fiscal enforcer.
Moreover, regardless of the outcome of these negotiations, Merkel, the EU and financial markets will have to contend with the fact that for the first time the far-right AfD is represented in the Bundestag. It came third, with 12.6% of the vote which, as a result of a number of small parties failing to meet the 5% threshold, resulted in the AfD winning 94 seats or 13.3% of the total 709 seats (see Figure 12). While the AfD is extremely unlikely to enter government, it has once again drawn attention to voters’ discontent with mainstream policies (including on immigration, domestic security and the direction for Europe) and to the influence which nationalist policies may yield. This has in turn reignited the almost-dormant debate about nationalism and Europe’s future.
Euro at a cross-road for now, scope for appreciation further down the line
As a result of this myriad of German, Eurozone and global developments, the Euro arguably finds itself at an important cross-road. I see little scope for rapid and/or sustained appreciation until the ECB announces the modalities of an extended QE program and a new German government is in place, with the risk biased towards bouts of Euro weakness.
Longer-term, however, a number of factors could drive renewed Euro appreciation, albeit at a likely slower pace than in April-August. For starters, the Euro does not appear particularly expensive at these levels – while it is 7% stronger than in early April, its appreciation has been far more benign than that of Sterling, the Dollar and Chinese Renminbi in 2015 (see Figure 4).
Lagged impact of ECB QE, policy risks in US/UK could work in Euro’s favour
More fundamentally, the lagged impact of the ECB’s current QE program is likely to continue to feed through to Eurozone economic activity medium-term. Its extension, particularly if accompanied by smaller monthly purchases of say €40bn, would signal the ECB’s ability and willingness to further reflate the Eurozone and contain fiscal and credit pressures while at the same highlight its confidence that macro trends are going in the right direction.
Conversely, there is still a non-zero risk that the BoE and Fed, which have cried wolf in the past, do not deliver on rate hikes at their policy meetings on respectively 2nd November and 13th December. At the very least, they could be forced to temper their hawkish language if macro-data, in particular inflation measures and Q3 GDP, disappoint in coming months. With markets pricing in a roughly 70% probability of the Fed hiking 25bp in December and an even higher probability priced in for the BoE, this would in turn likely see UK and US yields and currencies correct lower. With this in mind I would refer you to the comprehensive data and events release calendar in Asymmetric data and event risk (22 September 2017).
Even if the BoE hikes 25bp in November, I would expect it to signal that future rate hikes will be very slow and gradual. We could see a long gap between a November hike and the next rate hike, which could eventually undermine Sterling (as has been the case this year with the Fed’s slow pace of hikes underwhelming markets expecting a brisker pace of tightening and the Dollar weakening sharply).
UK and German government’s fortunes could once again reverse
The British government’s procrastination in the 12 months following the June 2016 referendum and glacial pace of UK-EU negotiations has set the bar low and markets have thus been encouraged by even modest signs of progress. But with the clock ticking and Brexit negotiations having to realistically be concluded by end-2018, markets may start to set the bar higher and react negatively to further delays.
Theresa May’s cabinet remains divided as to the modalities of a likely transitional agreement and the size of the UK’s likely divorce bill. The EU’s chief negotiator has torpedoed the idea of the British government linking the “divorce settlement” to ongoing access to the Single Market on preferential terms and continues to argue that the EU will not discuss the terms and conditions of the UK’s new deal in parallel with talks about the terms and conditions of the UK’s exit until further progress has been made on the latter. This includes the UK’s financial settlement, the issue of the Irish border, the treatment of EU nationals and more broadly the issue of immigration. With the ruling Conservative Party short of a parliamentary majority and having to rely on conditional DUP support, there is a non-negligible risk of key Brexit-related policies languishing in the House of Commons, in my view.
Finally, assuming that Merkel successfully cobles together a majority coalition, I would expect a degree of policy continuity both in terms of substance and style, which markets would likely welcome.
For starters, in the event of both the eurosceptic FDP and pro-Europe Greens being part of the government they would likely be junior partners, with Merkel benefitting from 12 years in power as Chancellor. Moreover, their respective policy stances would potentially cancel each other out although decision-making could be more protracted. In particular, I would expect Merkel to continue to push for a German rapprochement with France while resisting Turkey’s possible membership to the EU and wholesale financial bail-outs of other EU countries,
Moreover, Merkel has already started to backtrack on some of her less popular policies, including allowing mass immigration into Germany (asylum applications collapsed to 110,000 in H1 2017 from 750,000 in the full-year 2016). This will clip the wings of the far-right AfD which is already seeing political infighting and defections.
Finally, the German economy is strong and political parties – irrespective of their leaning – will likely be cautious in pushing for wholesale changes to economic policies which have delivered. Ultimately, I would expect markets to eventually refocus on the fundamental drivers of European bonds, equities and common currency, including the pace of the European economic recovery and ECB monetary policy.