Said Madame Lagarde, ‘I’m concerned
That strength in the euro’s returned
If that is the case
We’ll simply debase
The currency many have earned
Christine Lagarde, in a wide-ranging interview last week, but just released this morning, indicated several things were at the top of her agenda. First is the fact that the containment measures now reappearing throughout the continent, notably in France, Spain and Germany, will weaken the recovery that started to gather steam during the summer. This cannot be a surprise as the key reason for the economic devastation, to begin with, was the dramatic lockdowns seen throughout Europe, and truthfully around the world. But her second key concern, one about which I have written numerous times in the past, is that the euro’s recent strength is damaging the ECB’s efforts to support a recovery. The new euphemism from ECB members is they are “very attentive” to the exchange rate. The implication seems to be that if the euro starts to head back to the levels seen in early September, when it touched 1.20, they might act. Clearly, the preferred action will be more verbal intervention. But after that, I expect to see an increase in the PEPP program followed by a potential cut in the deposit rate and lastly actual intervention.
To be fair, most economists are already anticipating the PEPP will be expanded in December, when the ECB next publishes its economic forecasts. Currently, the program has allocated €1.35 trillion to purchase assets on an unencumbered basis. Recall, one of the issues with the original QE program, the APP, was that it followed the capital key, meaning the ECB would only purchase government bonds in amounts corresponding with a given economy’s size in the region. So German bunds were the largest holdings, as Germany has the largest economy. The problem with this was that Italy and Spain were the two large nations that needed the most help, and the ECB could not overweight their purchases there. Enter PEPP, which has no such restrictions, and the ECB is now funding more purchases of Italian government bonds than any other nation’s. Of course, there are more Italian government bonds than any other nation in Europe, and in fact Italy is the fourth largest issuer worldwide, following only the US, Japan and China.
As to further interest rate cuts, the futures market is already pricing in a 0.10% cut next year, so in truth, for the ECB to have an impact, they would need to either surprise by cutting sooner, or cut by a larger amount. While the former is possible, the concern is it would induce fear that the ECB knows something negative about the economy that the rest of the market does not and could well induce a sharp asset sell-off. As to cutting by a larger amount, European financial institutions are already suffering mightily from NIRP, and some may not be able to withstand further downward pressure there.
What about actual intervention? Well, that would clearly be the last resort. The first concern is that intervention tends not to work unless it is a concerted effort by multiple central banks together (think of the Plaza Agreement in 1985), so its efficacy is in doubt, at least in the medium and long term. But second, depending on who occupies the White House, ECB intervention could be seen as a major problem for the US inspiring some type of retaliation.
In the end, for all those dollar bears, it must be remembered that the Fed does not operate in a vacuum, and in the current global crisis, (almost) every country would like to see their currency weaken on a relative basis in order to both support their export industries as well as goose inflation readings. As such, nobody should be surprised that other central banks will become explicit with respect to managing currency appreciation, otherwise known as dollar depreciation.
Keeping this in mind, a look at markets this morning shows a somewhat mixed picture. Yesterday’s strong US equity performance, ostensibly on the back of President Trump’s release from the hospital, was enough to help Asian markets rally with strength in the Nikkei (+0.5%) and Hang Seng (+0.9%). China remains closed until Friday. European markets started the day a bit under the weather, as virtually all of them were lower earlier in the session, but in the past hour, have climbed back toward flat, with some (Spain’s IBEX +0.95%) even showing solid gains. However, the DAX (+0.1%) and CAC (+0.3%) are not quite following along. Perhaps Madame Lagarde’s comments have encouraged equity investors that the ECB is going to add further support. As to US futures markets, only NASDAQ futures are showing any movement, and that is actually a -0.4% decline at this time.
The bond market, on the other hand, has been a bit more exciting recently, as yesterday saw 10-year Treasury yields trade to their highest level, 0.782%, since June. While this morning’s price action has seen a modest decline in yields, activity lately speaks to a trend higher. Two potential reasons are the ever increasing amount of US debt being issued and the diminishing appetite for bonds by investors other than the Fed; and the potential that the recent trend in inflation, which while still below the Fed’s targeted level, has investors concerned that there are much higher readings to come. After all, core PCE has risen from 0.9% to 1.6% over the past five months. With the Fed making it clear they will not even consider responding until that number is well above 2.0%, perhaps investors are beginning to become a bit less comfortable that the Fed has things under control. Inflation, after all, has a history of being much more difficult to contain than generally expected.
Finally, looking at the dollar, it is the least interesting market this morning, at least in terms of price action. In the G10, the biggest mover has ben AUD, which has declined 0.4%, as traders focus on the ongoing accommodation of the RBA as stated in their meeting last night. But away from Aussie, the rest of the G10 is +/- 0.2% or less from yesterday’s closing levels, with nothing of note to discuss. In the emerging markets. THB (+0.7%) was the big winner overnight as figures showed an uptick in foreign purchases of Thai bonds. But away from that, again, the movement overnight was both two-way and modest at best. Clearly, the FX market is biding its time for the next big thing.
On the data front, this morning brings the Trade Balance (exp -$66.2B) and JOLTS Job Openings (6.5M). Yesterday’s ISM Services number was a bit better than expected at 57.8, indicating that the pace of growth in the US remains fairly solid. In fact, the Atlanta Fed GDPNow forecast is up to 34.6% for Q3. But arguably, Chairman Powell is today’s attraction as he speaks at 10:40 this morning. I imagine he will once again explain how important it is for fiscal stimulus to complement everything they have done, but as data of late has been reasonably solid, I would not expect to hear anything new. In the end, the dollar remains range-bound for now, but I expect that the bottom has been seen for quite a while into the future.
Good luck and stay safe