The post was written in December 2013, but the arguments are still valid today and will continue to be valid in the future.
We present twelve reasons that could sustain a further euro appreciation to $1.40 or even 1.50 in the upcoming two to four years. The main one is that Germans are net global creditors and Americans net debtors. This is reflected in fiscal and monetary policy and in investors’ behaviour.
Update May 2015
The massive depreciation of Brent oil, helped by OPEC’s massive supply and the desire to drive U.S. shale oil producers out of the market, surprised us.
Temporarily there was the phenomen called “Euro Glut“, that challenged our reason 7 below: The dollar did appreciate – but as we expected – temporarily.
- European banks and investors moved their trade surpluses into the United States, in the hope of rate hikes.
- FX speculators built up a huge position against the euro.
- Central banks in Emerging Markets over-hedged with the purchase of dollars against a collapse of their currencies
- Moreover, the big choice of USD-denominated investments, e.g. in the tech sector, increased demand for dollar. Those companies are not necessarily all Americans.
At the end, however, cheaper Brent oil prices help to increase European exports, they will reduce Southern European unemployment and should finally lead to higher German wage inflation.
Update Summer/autumn 2014:
Since summer 2013, many currencies in the Emerging Markets have depreciated. This created inflation via the currency, in particular oil became expensive in local currency, while it did not change a lot in dollar terms. To stop inflation central banks had to tighten: Borrowing rates rose, while easy money from advanced economies did not flow as before. In particular Germany is strongly dependent on sales of machines and other capital goods to EM. Additionally sanctions against Russia and the “reverse sanctions” hit German exporters. Knowing that emerging markets would slow, our forecast was a timeframe of two to four years, time to recover for both EM and Europe.
Update ECB press conference January 9, 2014:
Draghi’s key phrase was probably:
A few Euro countries have deflation. Deflation might be a needed adjustment for them. We do not expect deflation for the euro area as a whole.
The financial establishment bets on a strong dollar, how long will this period last?
Written in December 2013:
The opinions of the financial establishment are usually very volatile: in Summer 2011, they were very bullish on emerging markets and gold, since the beginning of 2013, they have become dollar bulls.
But what are the reasons for our long-term euro bullishness?
Reason 1: Americans are net debtors, Germans net creditors
The German net international investment position has improved from zero in the year 2000 to 43% of GDP recently, while the American position continues to weaken.
Americans have become net global debtors. Europeans, in particular Germans, are net global creditors.
Therefore Americans and their Keynesian economists would like inflation to wipe out the (housing) debt, but Germans want to keep up their purchasing power. Germans hate inflation, with the euro crisis and ECB money printing this fear has intensified. With the U.S. and Southern European housing crisis, Americans have become debtors and Germany the clear leader for European fiscal policy and the implicit European financier.
European and German leaders have successfully smashed the rational expectation in the European periphery that salaries must always rise – and gave a halt signal to inflation (see also labor costs graph below). This has reduced the excessively high peripheral government bond yields and should limit over the longer term the rapid rise of public debt.
When Germans want deflation or low inflation, and Americans want inflation, they shall obtain their wishes via their currencies. A strong euro will help to remove German inflation fears, a weak dollar and high inflation shall wipe out American debt.
Reason 2: Trade flows are paramount
Until 2007/2008, we lived in period when capital flows were far more important than trade flows, the carry trade was in vogue. After the crisis there was a period of risk aversion and high volatility until 2012; and in the end currencies with trade surpluses, like the European CHF, SEK and NOK but also the Korean Wong and the Chinese Renmimbi, greatly appreciated. The JPY initially inched up thanks to trade surpluses, but the end of nuclear energy and the reliance on imported oil created a trade deficit. Risk appetite and Abenomics did the rest and destroyed Japanese purchasing power.
Since the end of the euro crisis that brought global austerity and low inflation, trade flows continue to be paramount. The next victims were emerging markets with trade deficits like the Indian Rupee, the Indonesian IDR and the Brazilian BRL. Brazil has a trade surplus, but has high financing costs in US$.
Some pundits suggested investing like before 2008, shorting the Swiss franc – the currency with the highest surplus – and investing the proceeds in US Dollars and in currencies with high carry (e.g. AUD or NOK), which was a fatal strategy. The hedge fund FX Concepts was one of the victims.
The euro zone has achieved a huge trade surplus but not yet appreciated a lot. Goods are produced in Europe and foreigners need to pay in euros, increasing the demand for the single currency. As the euro collapse fears have receded and no higher US interest rates are in sight, European companies often do not hedge their dollar exposure. Germans and other Northern Europeans have huge savings and in fear of the Federal Reserve, the protector of their enemy – the debtors – they continue saving their money in euros and not in dollar.
How to observe trade flows: During hours without fundamental news, especially during European or Asian trading, the euro very often appreciates; no matter if stocks go up or down. Good U.S. or bad European fundamental data is able to stop this tendency; but only for a limited time.
Reason 3: Equity valuations drive capital flows
In the absence of interest rate differentials, for capital flows the asset market model is paramount: American stocks seem to be overvalued against P/E ratios, while European ones might still be undervalued, given that the European business cycle follows the American one with a lag of two or three quarters.
American investors buy a lot more European equities than the opposite, Europeans often prefer bonds. This is visible in the net positive portfolio investment inflows below. Even during the euro crisis the value barely fell into negative territory, but seems to stabilize now at 1.5% of EU GDP. European direct investments are a net outflow, but they are directed more to Emerging Markets and not to the U.S.
European investors have burned their fingers twice already with U.S. investments:
- The first time during the dot-com bubble and the following dollar collapse from EUR/USD 0.80 in 2000 to 1.60 in 2007.
- The second time: the Fed’s QE1 and QE2 drove foreigners out of U.S. investments, for many the Fed remains the encarnation of inflation.
In particular Germans, the owners of the biggest trade surplus, prefer to invest in local stocks (often with global exposure!) and do not trust the love for debt in America, this preference is reflected in the recent huge run-up of the DAX.
In times of zero interest rates, risk-averse funds prefer the currency with the highest real interest rates; and thanks to low inflation figures, this is the euro. Recently the Norwegian Krone has strongly depreciated: the reasons were the higher Norwegian inflation, a diminishing trade surplus and a dovish Norges Bank.
Reason 4: The Fed is a dovish, while the ECB is a hawkish central bank
The ECB has a pure inflation mandate, with the inflation rate “below but close to 2%”, hence it is by definition a hawkish central bank. The Fed has a double mandate: high employment and an inflation target of 2 or even better 2.5%, hence it is by definition a dovish central bank. American economists are mostly Keynesians, Germans are ordoliberals and supply-siders.
The discussion about negative ECB deposit rates created an outcry at German banks. For the ECB there are no unconventional methods, like QE, available to create inflation. Still in 2012 Draghi said negative rates would destroy the credibility of the central bank, and it would be against European contracts. Thanks to dis- and deflation, peripheral yields have stabilized so that even a long term refinancing operation (LTRO) would not be feasible now.
Hence the ECB’s race to the bottom is finished, while the Fed is still doing its massive QE3 programme, which are implicit negative rates.
Reason 5: The euro is the new Deutschmark, just as European leaders wanted
Former ECB chairman Jean-Claude Trichet calmed down German fears on several occasions that the euro is as stable as the Deutschmark when they were concerned about inflation.
By 2013 austerity and conditionality clearly triumphed over “whatever it takes”. Since they cannot devalue the currency, the European periphery is forced to devalue internally: lower labor costs are required. Many of them have already started in wage deflation, Italy and France might follow. European leaders explicitly wanted a reduction of peripheral labor costs to increase competitiveness and become more productive. They are on a “good” way: de- and disinflation is expanding, leaders are increasing price stability and the euro’s value.
Price stability, as if the euro were the Deutschmark.
Between 1990 and 1995, the Japanese yen rose to record-highs, five years after the bust of the bubble. The dollar fell from 150 to 90 yen.
Reason: Japanese price stability and low inflation.
So the euro zone has low inflation, investors have no fear that their money is eroded, while with the Fed’s aggressive policies and higher US inflation, money loses its value. The euro has real positive yields for many Euro zone government bonds, while investors are sure that the Fed wants to move real yields into negative territory (U.S. real yields are negative for 0 to 5 years).
A strong euro is no big issue for the euro zone
At 1.32 the German “unit-labour cost-based euro” was still 10% undervalued against the year 2000. Moreover, German high-quality exports are relatively FX rate insensitive. If the euro costs 1.30 or 1.50, there is no big difference for them, also because supply chains and production has partially been globalized. The French trade surplus with the U.S. was highest in 2007/2008 when the euro hovered around 1.60.
The European periphery sells mainly into the euro zone without currency exposure. A recovering German demand is helping them. German exports to the U.S. are ten times higher than exports from Spain to the U.S., but German population less than two times higher than Spain’s. 85% of Spanish exports go to euro or euro-related countries (like GBP, CHF, SEK, PLN), a recovery of German demand will help them to export themselves out of the crisis. Thanks to rising Northern European and British wealth, Spanish tourism is crisis-resistant and covers 113% of the Spanish trade deficit.
According to new research, the periphery has started to turn from local customers to exports. But structural reforms take time: We will need to wait another two to four years until both export surplus and consumption could rise together. In the meantime, unwillingness to reduce wages and labor costs, e.g. in France or Italy, will be punished with higher unemployment.
Reason 6: Basel III will depress European credit growth for years
The Basel III rules require from banks a higher capital to (risk weighted) assets ratio. For years Germans deposited their increasing wealth and company profits at banks and blew up their liabilities. Rising home prices did the rest, both banks’ liabilities and assets have strongly increased.
With the post-financial crisis anti-debt sentiment, European hawks are suggesting that most European banks do not have enough capital. As usual, European investors are fearful, hence raising new capital has become difficult. Therefore assets must shrink; this implies lower credit growth. Lower European money supply, the equivalent of credit on the other side of the balance, implies that a higher supply of dollars needs to be converted into euros: the currency with lower supply appreciates.
Sure, without credit growth, new business is difficult, but have you ever tried to start a new business in socialist Europe, while the US is slowly copying the European model?
Reason 7: Tapering does not imply a stronger dollar against euro
Yes, there will be some good U.S. data, U.S. GDP growth will be somewhat higher than that of the euro zone. The Fed will reduce its asset purchases.
Yes, the Fed will taper: then the dollar will rise for a couple of hours or days, but that’s it. A taper or a taper rumour is always a good moment to buy: buy stocks, gold or the euro but not the dollar.
Reason 8: The Fed’s double mandate is a mission impossible
In the current “race to the bottom” for interest rates, the Fed’s double mandate is a mission impossible. They are able to:
- EITHER achieve full employment (aka 6.5% according to the Evans rule) – thanks to rising competitiveness of U.S. firms via low or no wage increases and consequently lower inflation than targeted,
- OR achieve the inflation target of 2.5% according to the Evans rule (currently the PCE GDP deflator is 1.4%). Higher U.S. inflation implies higher American wages as opposed to falling European labour costs. Higher wages will destroy American jobs in the global competition for higher company profits without physical and virtual boundaries. Boundaries that still existed in times of the strong dollar (early 80s or late 90s)
Achieving both low unemployment and 2.5% inflation is hence a mission impossible.
Even Bernanke affirmed that “the target for the federal funds rate is likely to remain near zero for a considerable time after the asset purchases end”.
Recently, American companies have created (part-time) jobs, yes, but GDP growth is far behind.
More people in work, a slight recovery in manufacturing and the weaker oil price have helped to reduce the U.S. trade deficit, but more people in work are now destroying company margins, if Americans do not spend….
The 1.4% rise in personal expenditures (PCE) for Q3 is insufficient. The result is that European company margins will be rising more than American ones, which lifts again the euro, due to reason 2 above.
This time the Fed has created just a mini bubble
In line with Larry Summers “secular stagnation”, we believe that the U.S. is currently in a bubble based on rising house prices and initially higher spending. As opposed to 2002-2007, this time the bubble will be far smaller: the majority of Americans still sits on debt, while a minority profited on higher stocks or price increase of rather expensive houses, often in metropolitan areas. With global competition and so many Americans out of the labor force or working part-time, wage increases are still far off.
Reason 9: Fed’s mini bubble has reduced the need for European credit growth
Small or negative credit growth does not imply that GDP growth is negative. The European trade surplus is in the end the equivalent of company profits in global trade, for example in trade with the U.S. Many European companies are able to finance themselves with higher profits rather than with new loans. And the profits are deposited in European banks, strengthening the banks’ balance sheets.
Reason 10: Europe’s GDP has bottomed out
Europe has no big debt issue any more, but as Natixis said it has rather too much money, a savings glut.
Europe has done a necessary adjustment, many countries adjusted their savings rate upwards to the 14% average levels of Northern Europe (see under reason 2), while the savings rate is 4.7% in the U.S. This had negative repercussions, auto sales went to record lows.
True, France and Southern Europe lived beyond their means until 2008, but thanks to their higher property values households are still richer than Germans. Unemployment rates in countries like Spain or France are as high as in the 1990s, but not more. Since 2005 German companies have created 3 million new jobs despite a falling population and the financial crisis. Employment in Germany is still rising by 1.2% per year, recently thanks to immigration from the crisis countries. Eastern Europe has recently restarted its rapid rise, many Italians and Spaniards now work in Poland. The poverty threshold in Italy is 991 euro for two people, in Poland it is half of it, no wonder that poverty rises more quickly in Italy.
Reason 11: Oil prices and demand in Emerging Markets
The Fragile Five (Brazil, Russia, India, Indonesia and South Africa) were some of the countries that have experienced high salary increases for years. Their rising purchasing power created the necessary demand that avoided a “global Great Recession” despite the American Great Recession. On the other side, higher wages and a rising trade deficit have weakened current accounts and their competitiveness. Lower European and own demand lowered commodity prices which again depressed the commodity currencies among them – RUB, ZAR, BRL and partially IDR.
Admittedly, the fight against inflation in the Fragile Five will take another two to four years, but with slowly rising global demand, oil and commodity prices should inch up again. Therefore, a taper will not put the BRIIS into constant danger. They have accumulated many currency reserves so that they depend far less on U.S. capital than they did before the year 2000. Thanks to their trade surpluses, China and Russia are nearly independent of U.S. investments.
Oil demand: This implies that growth of emerging markets and consequently demand for oil should continue to rise. Between 1996 and 2012, both India and China have doubled their oil consumption per person, a tendency that stopped in 2012 with less European demand for Chinese production. A global recovery should move oil consumption on trend again.
Oil supply: Despite the “shale revolution“, there will be no strong oil glut like in the early 1980s or a technology bubble that could direct investment out of emerging markets, reduce oil prices and help the U.S.
Still, shale oil is for the U.S. an insurance that future oil and gasoline price increases will be limited. Europeans go the other way, they develop alternative energies and reduce their dependency on oil.
Reason 12: China diversifies into Euros
Douglas Borthwick is one FX and macro analyst that endorsed our euro 1.50 bet. He reckons that by June 2014 the euro will reach 1.50, this is quicker than we think.
In a Bloomberg podcast Doug has provided two important reasons:
- The People’s Bank of China will diversify away from the dollar and buy more and more euros.
- As we explain above, disinflation and a stronger euro implies lower bond yields for the periphery. Reducing borrowing costs is more important for them than a weak currency.
The counter argument and the rule of thumb
There is just one important counter argument. Will Americans really continue spending?
The tea party, churches, conservative and libertarian politicians have managed to gain more and more influence. A big part of the population might listen to their arguments and discontinue their over-spending habits. If the U.S. PCE remains clearly below the latest 1.4% increase per year, then oil prices will be hit and Americans could finally improve their trade deficit. In this case the dollar should appreciate.
To give a rule of thumb:
We think that the U.S. personal consumption expenditures (PCE) will rise between 1% and a maximum of 2.5% annualized for many years and this is definitely euro-bullish. A PCE value that persists over 2.5% could trigger Fed rate hikes, one under 1% would play for the greenback via lower oil prices.
P.S.: Remember that FX rates never appreciate in straight lines. Some parts of this essay might be satirical but the essence remains the same: we think that the euro will get stronger over time.
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