"Keep you in the dark… You know they all pretend"
- Foo Fighters, The Pretender
April has begun with something of an adjustment in financial markets. In FX, many of the trends that were in place before the Easter Holidays have seen reversals so far in April – notably in EUR vs. USD and GBP. The fact that the USD has weakened against the EUR following on from the surprisingly strong March US employment report has also caused some consternation and has led a wave of commentators to declare that the market has now fully priced the US recovery story and thus the USD can now resume its (terminal?) decline against major currencies – most notably the EUR. We disagree.
From our perspective, while there are some factors that we consider to be more troubling for the USD in the longer term (including a fiscal policy stance erring too close to modern monetary theory?), we continue to see the current backdrop as one where the US growth trajectory increases its advantage over the rest of the developed market (DM) economies – not just due to vaccine/virus dynamics. In fact, there has even been a very modest narrowing of the US advantage – which many analysts have added to their reasons for EUR bullishness. From our perspective, in addition to the difference in vaccinations, the monetary and fiscal stimulus in the US remains significantly bigger than the rest of DM (especially when you factor in the change in monetary stimulus relative to the start of 2020, not just the current absolute levels). Furthermore, a number of other factors also contribute to US outperformance, such as greater economic dynamism, improved household balance sheets, and importantly fewer pre-existing conditions. All these factors continue to favour the USD in our view.
So what about in the rates space? I have read a lot of commentators this week arguing that US front end rates are now fully priced even under optimistic scenarios for the inflation outlook. Well, if we look at the eurodollar futures strip, then EDZ1/EDZ2 (an approximation for the expected rate hikes in the calendar year 2022) is currently pricing a little under one 25bp rate hike, and EDZ2/EDZ3 is pricing a little over two 25bp rate hikes for 2023. That doesn’t feel overly optimistic to me – especially given the extent of the potentially unprecedented economic growth the US could see over that period (and bearing in mind that is only roughly halfway back to where we were at the start of 2020). Please see chart below.
However, I am equally not convinced that this is the dominant factor for FX. Yes, historically the 2-year rate differential has been an important factor in FX rates, but this correlation faltered dramatically around about the same time as the widespread adoption of negative interest rates and has been of little or inconsistent predictive power in major FX for some time now.
Instead, we are more of the view that going forward the dominant driver of FX valuation is the capital account, not the current account (which as we alluded to earlier, is perhaps more concerning over the long run). Indeed, if the US rate curve has fully priced an ‘optimistic’ recovery scenario, then it is likely that the US will attract bond inflows – and if, as we suggest, the growth backdrop for the US is also likely to widen further, then capital should also flow into equity and other US risk assets. I struggle to see how this is a scenario that undermines the USD.
Indeed, if we look at things from the opposite direction, the significant US supply of bonds to finance the fiscal expansion will likely be countered, as we have discussed, by foreign demand – as a function of its significantly positive yield curve (and exacerbated by the fact that due to quantitative easing purchases by the global central banks, the vast majority of the ‘free float’ of global bonds are Treasuries). This keeps rates low for the US, thus fostering a faster growth acceleration in the US. In the rest of the world, however, where the recovery is temporally behind the US, the impact of US rates likely causes tightening of monetary conditions and thus weaker economic growth.
Ultimately, from our perspective, the rebound outside of the US (in DM terms) will not be as strong or as sustained as that of the US. More importantly, the level at which it stabilises – the equilibrium or potential growth rate – should be not only higher in the US, but that margin likely widens.
A comparison of the Federal Open Market Committee and European Cental Bank (ECB) minutes released over the past days are a case in point. The Fed emphasises patience in its removal of accommodation, while revising growth expectations significantly higher, waiting to base policy action on “observed” rather than “predicted” progress towards its goals. The ECB minutes, on the other hand, note that “economic weakness might continue into Q2 and beyond” and that “market optimism wasn’t shared by firms or households.”
Are we there yet? From our perspective we do not see the US yield curve as necessarily fully priced. But, if the majority of the market does, then we see this as a factor that supports the USD through the capital account, not undermining the USD through a correlation that over recent years has been at best mixed. For now, at least, while there may be many pretenders, the backdrop continues to suggest to me that the USD remains exceptional.
Bloomberg and Eurizon SLJ Capital Limited, data as at 9th April 2021
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