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“Reality leaves a lot to the imagination”

John Lennon

For a long time now, the discussion on this page, while trying to offer a balanced debate, has consistently concluded that the dominant macroeconomic forces have argued in favour of USD strength - and for the most part EUR weakness. At the back end of last year, this bias was driven by a rapid recovery in the US labour market and the Federal Reserve (Fed) abandonment of the ‘transitory’ inflation narrative, that led to sharply wider yield differentials.

More recently, we have argued that the level of excess demand in the US - or the level of underlying growth, has significant implications for the reaction functions of the respective central banks in the face of a more pernicious energy price spike. In effect, the energy cost differentials have widened to the detriment of Europe, further squeezing household disposable incomes and aggregate demand (and thus also widening growth differentials in favour of the US).

And most recently, the war in Ukraine has further restricted global supply chains as sanctions restricted the flow of goods, components and services while flight and sea travel are also affected. This, alongside the implications of higher commodity prices and tighter financial conditions (potentially also restricting financing channels) have led analysts to significantly downgrade growth forecasts for 2022. All the above factors are contributors to our recent trading and commentary bias in relation to EUR vs. USD

However, of late there are signs that EURUSD has been used (increasingly) as the primary ‘risk-off’ hedge for the negative global connotations of the Ukraine war. The rationale being that the USD remains the dominant (and importantly positive yielding) global safe-haven currency, and that the geographic proximity, energy reliance and greater financial integration (or financial market exposure) factors weigh on the EUR.

However, from here, it is not so clear that a further deterioration of the situation would continue to asymmetrically impact Europe, or the EUR. Indeed, a further deterioration of the situation may leave the aggressive market pricing of US rate hikes vulnerable - even if the inflation backdrop continues to support normalisation. Conversely, while a moderation or improvement in the situation likely does little to ease the near term inflation impact, it would likely have an asymmetrically positive EUR impact. While we see a resolution of the heightened tensions between Russia and the West as almost impossible in the near term, some form of coordinated peace agreement or ceasefire between Russia and Ukraine is perhaps much more plausible. Again, this could potentially be disproportionately EUR positive when we factor in the likely short EURUSD positions that are in place as hedges against a further deterioration.

There are also some signs that there has been something of a capitulation in markets of late, the significant degrossing of equity risk that occurred into the recent spike lows for example, or the huge spike and substantial rebound in the EURUSD risk reversal (or options skew). We could certainly make the case that the short term market is likely significantly short EURUSD.

Some regular readers may be thinking that this piece is written by an imposter, or it is Russian disinformation, and to caveat all of the views above, there are still a significant number of factors that point to protracted EUR weakness. Today we are just making the point that we have turned more neutral on the EUR in the near term - maybe even mildly positive!

This week’s European Central Bank (ECB) meeting brought some of the negatives back into focus - peripheral spreads were not happy with the announcement of continued (accelerated?) tapering of QE purchases, and this may still act as a headwind to normalisation. It is also clear that eurozone growth will start the year on a very fragile footing - the president of the ECB pointed to negative growth in Q2, led by Italy and Spain, but in maintaining the (albeit gradual) progress towards monetary normalisation, the president of the ECB did allude to (again albeit gradual) improvements.

Going into the meeting most analysts were expecting the uncertainty around the Ukraine war to bring with it a policy pause, a wait-and-see approach from the ECB. However, while there were some voices on the Governing Council (GC) who advocated such caution, the active message was that normalisation will continue, in a gradual, data dependent manner. This emphasised the primacy of the inflation mandate (and likely the significance of the hawkish contingent), while adding sufficient optionality and flexibility to the forward guidance in relation to interest rates to satisfy the dovish end of the GC spectrum.

The updated forecasts from the ECB are also worth mentioning. Growth was revised only very modestly lower to 3.7% in 2022, from 4.2%, and inflation at the forecast horizon (2024) was only revised up to 1.9% (from 1.8% previously) - still below target and thus consistent with a very accommodative monetary policy setting.

There are many factors that will weigh on the monetary policy reaction function of the ECB going forward; such as the continuation of the current escalated conflict, energy costs, the stickiness of sanctions, and the ECB have committed to publishing forecasts under adverse and severe scenarios (likely to highlight a more stagflationary flavour to the balance of risks). In this regard, the sensitivity of both inflation and growth to negative risks will play an important function in the market response to future events - especially if for example inflation (upside risk) is more sensitive than growth (downside risk) to the ECB’s scenarios.

Outnumbered by Hawkish voices?

However, it is clear that even against the current acute uncertainties, there are members of the GC who advocate continued policy normalisation. For now, the ECB have managed to square the divergence of views on the governing council and they may continue to do so for a little while longer by ‘talking hawkish, acting dovish’ to satisfy the divergent demands of member states. Nevertheless, divergence of views is likely to widen, through the year and not narrow. The president of the ECB’s job will get harder, not easier. At some point difficult decisions will need to be made.

Structural negatives for the EUR remain - for example the weak demographics, low growth and low yield environment will continue to warrant capital outflows (even if rates eventually sneak above zero). Ultimately, we believe that we are at an inflexion point for financial markets, hopefully for the Ukraine War, and potentially for the EUR. After a long period of holding a negative view on the EUR (and positive view on the USD), to paraphrase John Lennon, all we are saying is that we are willing to give the EUR (and peace) a chance… for now.

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