As FX has become new everything on the market, we’ve been looking at some interesting signals.
As FX has become new everything on the market, we’ve been looking at some interesting signals. We believe the following applies for the time being, i.e. : the massive central banks’ intervening era. We only focus on EUR / USD as no other region offers a similar trust in the future than EU and USA.
FX, at the end of the day, should be something that equalizes the purchasing power of different currencies under constraint of similar inflation rate, attractiveness of non-risky assets and, of course, the same kind of trust carried by the economies.
A currency is a credit on a economy. It allows anyone to claim a good and service of the value of its money. It means that if I produce a Toyota pick-up in France, I sell it against euro, I sell those euro against dollars, I should be able to buy a Toyota pick-up (or an equivalent car) in California.
For the first time in many decades, USA and EU have similar inflation and growth rates. It means that FX valuation might be reduced to attractiveness of risk free assets (i.e. : interest rates differential) and relative purchasing power.
Here again, we’ve been living in a ZIRP – zero interest rate policy - world (or almost so) for a decade. It means that only relative purchasing power is at play.
Let’s take a step back. We’ve got the ECB printing money like an animal (80 billion euros a month) and the inflation rate staying stable below 2%. In other words, the velocity of money, have been decreasing at a dramatic pace, courtesy of the Bâle-ish, Tier 1-ish regulation but also recession post-08. One more step forward, it means that while velocity has stabilized in the US, it’s still in the emergency room in the EU. Bottom line, what actually matters when looking at relative purchasing power is not really the level of assets owned by the central banks, but, as expected, the monetary mass.
The monetary mass is somehow only a concept as it is not measurable (M3, M4, etc.). As a reminder, in a quantitative monetary point of view : With M : monetary mass, V : velocity, P : general level of prices and T : production.
For the US: M$*V$=P$*T$
For the EU: M€*V€=P€*T€
And since, economies are interconnected, we have: M€*V€/ P€*T€ = M$*V$/ P$*T$ * FX
FX depending on the law of supply and demand, supply and demand being summarized by net capital inflows which are driven by attractiveness, trust and arbitrage opportunities.
The obvious flaw of this description is the impossible way of measuring T (production of goods & services without any dimension).
But let’s reflect a bit around it anyway :
It means that the only moving factor left nowadays is M1 or monetary base aka central banks assets (with inflation, growth rate evolving at a different pace, this would not be true anymore). As a consequence, let’s express the ratio of the FED’s asset compared to 1-Year Forward GDP:
Total Assets / 1Y-Fwd GDP
And do the same the for ECB and euro-zone economy. We can now look at the evolution of the relative weight of those ratios:
Index = ( Total FED Assets / 1Y-Fwd U.S. GDP ) / ( Total ECB Assets / 1Y-Fwd E.U. GDP )
Since inflation is stable both in USA and EU, it means that regardless of the pace of QE, the only thing that matters is the change in pace of QE. In other words, since velocity is decreasing in EU, current QE gets it even. We represent the year on year evolution of the index in the graph below. We can see that after the “trust” adjustment in 09, the evolution of the central banks assets is explaining the sense of the moves in FX.
Let’s assume now that GDP in the US and in the EU will stay in the same range for the coming 12 to 24 months. On the one hand, the FED told us they would like to diminish their asset by 2 trillion by 2022.
It means 500 billion in reduction.
On the other hand, the BCE is still involved in an 80 billion per months quantitative easing. As it appears that EU economy is in a better shape (even if it still falls short the 2% target, and necessary, inflation rate). Therefore, QE might be reduced. And that’s what the market assumed after Mario Draghi’s last speech. Let’s assume then a VERY aggressive QE tapering (to be conservatives): from 80 to 40 billion per month. If it’s announced, as suggested at the autumn, it would mean it will begin somewhere in 2018. Let’s assume January 2018.
It means a 40*9 = 360 billion decrease from the current pace of QE.
As conclusion, even in the most aggressive assertion considering the poor velocity at play in EU, the differential will stay largely in favor of a dollar reversal. As soon as the lack of executive leadership in the US (which brings about a “trust discount” on the dollar) is resolved, and when the changes in monetary policy are confirmed, the market will go back to its fundamentals and we should witness a sharp rally in the dollar.