French Support of Eurozone Reaches Multi-Year Highs: Euro Currency Demand to Remain Firm

french ez support 070517

The sentiment tide has turned favorable for the euro.

The types of existential threats which hampered the euro currency during the European debt crisis have largely receded for the time being.  EU citizens do not seem particularly interested in following the UK down the path of currency devaluation, inflation, and political turmoil by leaving the eurozone.

Demand for the single market currency will remain firm as the European economy continues its stable trajectory and the initial consequences of Brexit serve as a deterrent to others.

Longer term, we do expect to see perceptions improve regarding the decision by the UK to leave the European Union as the UK economy re-balances and the worst fears are not realized. Life will go on for Britons. There will eventually be appreciation for the modest claw back of British sovereignty, though the UK and EU will remain close economic allies out of geographic proximity and necessity.

Euro Set to Rise on Reversal of Deeply Negative Bond Yields

Real interest rates are deeply negative in much of the Eurozone due to the combination of interest rate repression by the ECB’s bond buying program plus above-target inflation.

Take a look at the real 10y German bund yield below.

bund - cpi feb 2017

As I have pointed out, the further behind the curve a central bank gets, the harsher the snap back toward normalization is once the process to normalize is anticipated by market participants. No central bank is further behind the curve right now than the ECB.

Investors are pricing in two or three 25 basis point Fed rate hikes this year. No such expectations exist in the Eurozone due to Mario Draghi’s persistent, stubborn denials of even discussing normalization with the Governing Council—yet. We may be at a turning point in market expectations for the euro as the severity of political risk subsides.

The 2yr yield spread divergence in US-German government debt is at extreme levels of 221 basis points. You could cruise a row of mega tanker ocean liners through that spread. This suggests a higher EUR/USD if and when the spread narrows to historically normal levels, but most likely long before then. The 10y Bund real interest rate yield is so deeply negative during a period of increasing economic activity and inflation that probabilities suggest a brisk reversal higher in yields the moment markets start pricing in a post-QE Europe.

The exact timing of when the yield spread will close is not as critical as knowing what will happen when it does. Once the sea tide resides back from the beach, it will be apparent holders of European government debt were swimming without bathing suits. They will likely be standing along side short sellers of the euro who will also be… exposed.

In summary, now is probably as good of a time as any to make sure you aren’t holding long European bonds that look and sound an awful lot like time bombs. The same could be said for short euro positions. Long EUR/USD and EUR/GBP entries on political fear-based dips will provide favorable asymmetric risk/reward opportunities.

Market Impacts of Economic Populism and Elevated Debt Levels

The politics of trade protectionism, nationalism, and anti-immigration are the match which will ignite dormant inflationary gasses bubbling underneath the surface after years of short-sighted monetary policy experiments.

Governments have failed for several years to enact meaningful structural reforms that would set economies on a more sustainable path. This is just now beginning to lead to the realization of painful, inflationary solutions. Losses in real wealth and spending power for many advanced economy citizens in the name of “economic competitiveness” and “growing out of debt” are under way. Central banks are somewhat subtly engineering an inflation overshoot as it is implicitly understood that government gridlock, corruption, and incompetence are preventing wiser legislative solutions from coming to fruition. Central banks have been “the only game in town,” as coined by Allianz chief economic advisor, Mohamed El-Erian. In other words, growing out of debt with real growth, innovation, and productivity gains is much less likely at this point than inflating out of it with falling real wages, lower standards of living, and stagflation.

Real average hourly earnings in the US fell by 0.5% in January versus the prior month; nominal wages rose by 0.1% while the BLS CPI-U Consumer Price Index increased by 0.6%. Even excluding energy, nearly any measure of consumer prices leads to a trend of deteriorating real incomes and saving rates going forward. Bank of England Governor Mark Carney has warned of accelerated losses in purchasing power on the way for the United Kingdom.

While the UK’s 20.5% year-over-year manufacturing input price inflation in January was largely inspired by pound sterling depreciation after voting to leave the European Union, the reflation trend is a global phenomenon. Germany, Norway, Sweden, and countless emerging markets including Mexico, China, Chile, Turkey, and Egypt, are experiencing a pace of wholesale (PPI) price increases faster than has been witnessed since at least 2011. PPI increases of this magnitude are generally a leading indicator for CPI to follow suit, though wholesale businesses will absorb a portion of the input cost increases through margin contraction.

I have been warning about building inflation risks for the past couple of years. Contrary to what new Keynesian economic advocates will have you believe with their gravity and logic defying models, there exists a simple mathematical problem of too much debt and not enough productivity to legitimately grow out of it in developed nations with aging demographics.

Prominent demand-side economists such as Larry Summers have been advocating currency debasement, money printing, debt-fueled fiscal stimulus, and interest rate repression continually since the financial crisis. Paul Krugman famously called on then-Fed Chair Alan Greenspan to create a housing bubble in 2002 to replace the .com bubble bust. This cyclical mentality of monetary bubble manufacturing has been blind to the secular economic rot festering underneath those same policies. It has also had unfettered control of the levers within the world’s most powerful central banks for the past 20 years. Financial history books will eventually hold these highly flawed policies and their proponents accountable for doing little other than fueling the next great bubble—the credit bubble. Or, as I alternatively call it, the global QE bubble.

Keynesian economists calling for debt-financed spending, ultra-easy monetary policy, and demand-pull inflation during a period of economic stagnation is nothing new. It isn’t only the usual suspects, however, singing the inflationary gospel now. That is why we are at such a significant inflection point. The populist right is winning political momentum and its policy prescriptions are astoundingly inflationary—border taxes, import tariffs, currency debasement, immigration restrictions limiting the labor market supply, etc.

Economic populism is credited with giving birth to the new political paradigm. Its recent “scalp prizes” were supporters of the UK staying in the European Union and the entire US political establishment. Lines between the traditional political left and right have become blurred in the developed world. Right wing populist candidates are closely vying for power in the least likely places on earth one would expect—the Netherlands (Geert Wilders) and France (Marine Le Pen).

Established politicians and their party infrastructures are more at odds with each other than they have been in decades. Yet, grass roots supporters of what are typically opposing parties have converged as strange bedfellows in supporting several key areas of common ground: reforming global trade rules with the intention of better protecting their own domestic workers, reducing cronyism within big government and big business, decriminalizing marijuana, and protecting civil liberties from government overreach, to name a few.

US President Donald Trump has lashed out concerning a too-strong dollar and flirted with altering a decades-long US strong dollar policy. France Presidential Candidate Marine Le Pen wants to leave the euro currency bloc, take control of the central bank, kick out the immigrants, and print money to fund social spending; and this is coming from someone widely considered to be of the political right wing. What could possibly go wrong? This has not gone unnoticed in the FX market or the French bond market. I’m afraid we haven’t seen anything yet, however.

These inflationary macro trends will continue to surprise many, even if Le Pen is not victorious in the France elections this year. The easy monetary policy leanings of the establishment-left and nationalistic fiscal policies of the populist-right are in alignment. They are both clamoring for a wave of higher consumer prices to erroneously “fix” structural problems of high debt and low labor productivity. It is completely illogical and will only have the opposite effect, but that is beside the point.

I sensed a stronger populist undertone than given credit by the press before the UK referendum to leave the EU and before the US presidential election. My base case doesn’t currently have Marine Le Pen winning the France presidency this year, but there is little room for error in the upcoming election season in Europe. Economic populism is here to stay due to the alignment of interests between grass roots supporters of opposing parties against political elites in general.

Punishing the globalist-minded political elites who have presided over declines in living standards for middle and working class Average Joes throughout the developed world is no longer exclusive property of the hard left. The populist right wants to make its dent in the elites’ armor as well. The result of anti-elite political sentiment will have profound impacts on financial markets for the next several years and some of these impacts are relatively predictable.

Behind the tire marks of the new anti-elite political paradigm exists a trail of how we got here. Gross mismanagement of government budgets globally and the inability of labor to share in the economic gains created during the previous period of high productivity have contributed to a deep structural hole that might prove too deep to escape with a “healthy” type of growth. This is especially the case given the drop off in productivity in recent years and aging demographics. It has also created outrage amongst the masses who feel duped for trying to play by the same rules the elite class gamed in order to gain even more wealth; ie, the carried interest deduction allowing billionaire money managers to pay lower tax rates than electricians.

The current hot topic of “low productivity” is often lazily discussed as if it is the reason real wages have been stagnant (or falling) for decades. Low productivity is more of a post-Great Financial Crisis phenomenon probably caused by a misalignment of corporate incentives. With Zero Interest Rate Policy (ZIRP) and central bank quantitative easing (QE) flooding the capital markets with fresh cash, why invest in new equipment to improve worker productivity when you can simply borrow for a negligible cost and use the cash to immediately fund common stock buybacks, dividends, and M&A? Excessively easy monetary policy distorted market dynamics and reduced incentives to increase productivity. Additionally, governments used the temporary benefits of monetary stimulus as cover to avoid taking more unpopular measures to improve their structural situations.

A decade of global central bank activism paired with several dysfunctional governments did not permanently address very many structural issues. What it did is limit the immediate severity of the 2008/2009 financial crisis, inflate asset prices to bubble territory, boost employment mainly for lower paying service sector jobs, and change the composition of the next recession to an inflationary debt reset rather than a deflationary bankruptcy-based debt reset, thus destroying responsible savers to the benefit of debtors.

What kind of a market environment will persist in a political climate of economic populism combined with excessive global debt? Real wages will take a beating initially, as will fixed income markets. Equity indices will be tugged higher on the illusion of inflated corporate earnings and then yanked lower after resulting interest rate spikes. FX rates will have multiple “Brexit-esque” caliber events, causing pockets of illiquidity and displacements in rates. A targeted Chinese yuan devaluation of 15% or more within 1-2 years is likely as one prime example. Any implementation of border taxes or tariffs designed to protect domestic workers will likely be met with retaliatory actions that will greatly harm those same workers, unless the new trade rules are negotiated and agreed upon by both sides. Bilateral trade deal negotiations and politics could be the chief drivers of global markets for the next five years in the same way monetary policy divergences drove markets in the past five years.

The best case scenario is governments use a period of unsustainable increases in budgets and financing costs over the coming years as political cover to get leaner, more efficient, and more responsive to the needs of their citizens (hopefully this doesn’t cause readers to erupt into spontaneous laughter). In a glass-half-full world, wages will eventually catch up to price increases. Those who are unemployed, retired, renting their primary residence, net savers, or whose incomes are not closely tied to actual inflation will feel like they were on the wrong side of a crash. It probably won’t be a traditional nominal price crash so much as a crash in real terms; however, there could be flashes of both.

Ultimately, the same forces that have always been responsible for real wage increases and higher standards of living still hold true: high productivity, broadly enjoyed technological innovations that lower costs without displacing too many workers, and a peacetime dividend enjoyed during times of no major war conflicts. Does it seem like we are headed toward this scenario?

Remember this: when someone tells you the surest path to economic prosperity involves devaluing your savings, lowering your real wages, and paying down old debt with new debt—run away and call the police—someone is trying to rob you.

ECB’s Inflation Target Hit Early: Time to Move the Goal Posts

The Eurozone Consumer Price Index registered an increase of 1.8% year-over-year in January versus December’s reading of 1.1%. This means the ECB’s inflation target mandate of “close but below 2%” has effectively been satisfied at least a year earlier than intended.

Next comes a series of goal post moving exercises. Policy makers and central bankers in Europe desire continued stimulus pumping to help limp past the banking crisis in Italy, the ongoing debt crisis in Greece, and significant political risk posed by elections in France, Germany, and the Netherlands.

Expect central planners in Europe to disregard the steepening inflation trend for as long as possible. Public discourse will gravitate toward new arguments downplaying headline CPI. These will include shifting focus to core CPI, blaming transitory effects from higher energy prices, highlighting unfavorable base effect comparisons from the prior year, and potentially even fears of trade barriers constraining future global growth. The ECB will get further behind the curve to the chagrin of Germany. Bullish pressure will continue to boil hotter for the euro currency unless politics get in the way.

Why ECB Dovishness Will Actually Boost the Euro

Mario Draghi is one of the better communicators in modern central banking. Everything he conveyed during the ECB’s 19th of January press conference was intentional. Each time he was presented with questions about whether the ECB should consider winding down its bond buying program faster in light of strengthening economic and inflation data he repeatedly stated, “it wasn’t discussed.” The last thing the native Italian central bank chief wants is a market eager to front run an accelerated QE taper, causing an unstable spike in Eurozone bond yields and in the value of the euro. Any tiny crumb of hope tossed to the hawks risks massive market repercussions similar to the Bernanke-inspired taper tantrum of 2013. Maintaining ultra loose monetary policy risks a rubber band snap back toward tightening the instant the tension is relieved.

ECB’s Nowotny took the prevailing dovish tone a step further today by saying the ECB won’t discuss tapering at the March meeting either. Euro currency pairs quickly dropped 50 pips. But the move was short lived. The euro boomeranged right back up and then some. It is proving difficult at the moment to sustain EUR/USD below 1.07 without a new politically inspired catalyst. So what happened? Why are dovish ECB comments from officials either not effective or even counterproductive in the sense they are actually boosting the euro?

The ECB is undoubtedly behind the curve in tightening monetary policy. Markets know it. Inflation is sharply advancing higher in Germany to the point where it has been front and center headline news in the newspapers. Germany may be known for outsized fears of inflation but this time it is correct to have such views. Wholesale inflation (PPI) is gapping higher at an even faster rate in global regions which typically lead the others – China to name a big one.

If you believe as I do that the ECB is behind the curve in tightening monetary policy then you’d also believe digging in with continued dovishness puts it even further behind the curve. As long as you think the ECB has enough credibility to eventually catch up in the tightening cycle then the more dovish it is now, the faster it will have to tighten later to catch up. Dovish statements and actions will only strengthen the euro at this point because it raises the bar for how fast the ECB will need to tighten later. The only issue waiting in the wings with the potential to drag down the euro in a big way is anti-EU political risk. Consider monetary policy jawboning to be rendered ineffective or even counterproductive from here on out in inflicting losses to the single market currency. ECB dovishness will only boost the euro further.