Over the past weeks, the ECB and the FED were clear about their focus and zeal to re-anchor inflation and inflation expectations. While the US FED can truly focus on fighting inflation, the ECB has multiple fights to lead. The mere observation they lifted their 2024 core inflation estimate to 2.3% preludes a long journey to the 2.00% inflation target. However, next to addressing the inflation problem, the ECB must also prevent painful fragmentation across EMU long-term interest rates from taking hold. Another 2010-2012 sovereign debt crisis must be avoided at all cost. Everyone focuses on the 10-year Italian-German bund spread whilst the spread moves of semi-core countries like Belgium have weakened in tandem. Flexibility, optionality and gradualism have been the darling words characterising ECB policy.
Rhetoric and reinvestment flexibility in favour of the periphery (on redeeming principal and coupons out of the EUR 5 trillion large EMU government and corporate bond portfolio held by the ECB) will be doing the heavy lifting in containing fragmentation. Yet, a robust anti-fragmentation tool is called for. Urgently. In about one and a half years, we will be celebrating the 25th birthday of the euro. The ECB has no fiscal backstop like the FED and must assure the cohesion of the Eurozone. Establishing a proper, long-term solution to counter speculation against the usual suspects (i.e., government bond markets) is highly overdue. Optionality is reflected in the immediate, instead of a late lift-off in policy rates once the net, active large-scale asset purchase programs come to an end on July 1. Expectations are that the ECB will lift the deposit rate by 125bp this year and another 100 to 125bp over 2023, targeting a 1.75%-2.00% end point. Gradualism might be the sole path for ECB president Lagarde. A FED-style reaction function is not an option. A tightening cycle that is too aggressive might push Eurozone inflation expectations well below the 2.00% target level, thus increasing financial instability, fragmentation risks and a slowdown of the environmental sustainability agenda the ECB subscribed to.
As ECB and US FED reaction functions diverge, the EURUSD exchange rate has only started to adjust to such a scenario. Hence the title, 0.8231. On October 26, 2000, the pair reached a low at 0.8231. Effectively, during the dot-com bubble episode, USD strength was omnipresent. On March 10, 2000, as the NASDAQ peaked at 5132, the EURUSD closed at 0.9637. Seven months later, the pair had adjusted by 14 big figures to 0.8231 with the NASDAQ dropping about 40% towards 3081. In early 2001, the FED initiated an 11-step accommodation cycle driving the FED Fund rate from 6.50% towards 1.75% by the end of that year. Notwithstanding such accommodation, the equity bear market was not exhausted at all and kept the USD strong. The NASDAQ corrected 78% from its highs. The low print was reached at 1081 over October 2002. As a next equity bull episode of 6 years unfolded, the USD depreciated aggressively. From a 0.98 level in October 2002 the pair steadily strengthened to reach 1.60 by July 2008.
Today, we have the NASDAQ at 10.798. The index officially is in a bear market, down 30% YtD and -34.5% since the high reached on November 22, 2021 at 16.212. On November 22, 2021 the EURUSD closed at 1.1248. So the EURUSD has only corrected 7.5 big figures in this cycle. The probability that the FED’s resolve is stronger in fighting inflation got confirmed by hiking in 75bp increments. Expectations of pushing FED policy rates towards 4% or even higher is circling in many reports. The ECB announced a first hike of 25bp on July 21, followed by a 50bp hike on September 8. A defensive start. The probability for ECB hesitation is far greater than a FED hesitation.
Next to such a divergent policy scenario we are confronted by many obstacles in global trade. The EURUSD surge from below parity in 2002 to 1.60 in 2008 was conditioned on a global USD liquidity expansion and China entering the WTO. Globalisation at its best. Globalisation goes along USD weakness. Protectionism, geopolitical stress and onshoring work in favour of the greenback. USD hoarding has become a natural tendency by most governments (especially EM) and corporates. On top, central banks seem to have become immune to intense equity and bond market volatility & repricing. They have decided not to come to the rescue and define the current reset not as financial instability.
On the other hand, we might expect that G7 heads of state and governments enter the arena, reminiscent of the 80s, to discuss currency valuations. The Plaza accord struck among the G5 (US, UK, France, Germany and Japan) in September 1985, had to weaken the USD especially against the Deutsche Mark and the Japanese Yen. High monetary policy divergence and a mounting US federal and trade deficit were the cause and effect of an (overly) strong USD. The ‘EURUSD’ made a low at 0.64 in March 1985. The US government pledged to reign in their federal deficit. Japan and Germany were prompted to increase domestic demand through various tax measures. The parties agreed to intervene in currency markets in order to rebalance current accounts. A USD appreciation of about 48% between 1980 and 1985 reversed this and led to a depreciation of about 26% in the two years that followed. The Louvre Accord of 1987 was required in order to stop the USD depreciation and search for stabilisation of exchange rates. Back then, central banks focused on their mandate, stayed far away from the press and media. Providing colour to policy in speeches was the exception and not the rule as is the case today. Ministers of Finance were playing first violin. The pandemic became the catalyst for a change of guards as well. Over the next decade, expect heads of state and governments to lead with monetary policy authorities in a serving role. Currency valuation considerations might reappear high on international political agendas.
The USDJPY is a case in point. The JPY depreciated by a stellar 32% over the past one and a half years. The decline has become sort of chaotic since March. Policy divergence is extreme. The FED’s resolve contrasts deeply with the Bank of Japan’s choice to stick to yield curve control and large-scale asset purchases. USDJPY closed at 135.02, taking us back to levels witnessed during the dot-com bubble when the EURUSD traded well below parity. Albeit with a lag, the Euro would suffer from a similar policy divergence. Expect further Euro weakness in the months and quarters ahead.
The next G7 summit, hosted by Olaf Scholz, takes place in the Bavarian Alps between June 26 and 28. Next to climate neutrality and an equitable world, expect present central bankers and ministers of finance to discuss financial architecture, stability and currency valuation subjects. The Eurozone shows resilience across growth, labour markets and private sector balance sheets (households & corporates). However, the risks we face are commensurate. The burden of galloping energy costs, persistent supply bottlenecks and the potential for tougher Russia sanctions (read energy ban) could break the fragile resilience and warrant caution by the ECB. The odds for sudden Euro strength are low. A revisit of the lows seen 20 years ago might not be a base case scenario but should be contemplated. Financial markets cross uncertain waters. The nowhere-to-hide narrative is often mentioned. The USD currency might be an exception as a liquid safe haven.
