The Badger of Broad Street on the Dollar Vs the Euro

Anybody trying to understand markets should be aware they are not about facts, but expectations, anticipations, and the myth of 20/20 foresight to determine what the facts are going to be tomorrow. That’s one of the reasons why markets are so mesmerizingly exciting – once you are hooked, you are literally hooked.

As we draw towards the end of the first quarter of 2015, we’re at a very “interesting” stage in global markets. Aside from the US, which is on a different path, global stock indices from Frankfurt to Tokyo are generally higher (many are at record levels). It’s easy to understand why investors should start piling out of bonds and into stocks. They expect that 2015 is going to see global growth pick up.

Global stocks, especially in Europe, are on fire because the drivers of growth look to have perfectly aligned themselves – low energy costs, more competitive currencies (versus the dollar), historically low interest rates, low wages and pent-up consumer frustration after so much austerity. In recent weeks we’ve seen a raft of global economic agencies and central banks publish improved growth outlooks. Last year Europe’s economic outlook for 2015/2016 was for a flatline. Now, even countries like France are expected to post measurable growth.

Yet, despite the noise and stock market records, we really aren’t seeing these positive factors translate into critical indicators of sustained growth. Critical indicators like capital expenditure by companies (except in the US and UK) remain weak. We haven’t seen much major investments in new plant. Thus far, most corporates have been using any cashfalls from the bond new issue market in the ultra-low rate environment to pay off pension shortfalls and buy-back stock!

After such a long period of global recession in the wake of the 2008-12 Global Financial Crisis, and effectively zero-interest rates, you might expect the early signs of growth driving stocks higher would start to trigger rate rises… but no. It seems we are too early in this new cycle for that to happen.

In fact, many investors aren’t convinced a new growth cycle has begun!

This much is clear from the bond market, where interest rates remain at record lows meaning bond prices are at record highs. When yields are so low you would expect investors to start switching out of bonds and into stocks in the hope of catching rising dividend yields and higher stock prices. It’s happened – but only to a limited extent.

Instead we have all kinds of distortions led by global central banks, who are conspiring to keep rates “Lower for Longer” in order to keep fuelling growth. 26 countries’ central banks have actively eased rates during 2015. Some would argue that even the US Fed and the UK’s Bank of England are closet easers. The Fed was far more dovish than anyone expected last week, and Bank of England board members have been saying things like “rates are as likely to go down as they are to move up…”

We also have investors digging deeper down the credit curve in search of yield – for instance investors who bought ultra-safe US Treasuries at 3% a couple of years ago are now buying “high-yield” oil & mining firms yielding the same 3% today. They are trying to maintain returns to keep their savers happy, but they are taking on massively higher risks in order to do so. 

Going back to stock markets, the main driver for the optimism with regard to Europe’s growth prospects has been the weaker Euro – if the Euro is weaker then European exports look more competitive. The reason the Euro weakened was largely the expectation that the ECB would push through Quantatative Easing – which has now happened. As part of the theory goes: holders of ultra-low yield European bonds will sell and buy higher yielding dollar (and even sterling assets), which should push the Euro even lower.

At least, that was the case till last week, when the unexpectedly dovish Fed served notice to the markets that the mighty dollar has gone as high as it’s going to. Since then the Euro has rallied back 5%. Until then the Fed had been the major driver of currency moves – accepting a stronger dollar in return for kick-starting global growth across Asia and Europe.

As I said earlier, the US stock market has been the exception to the strong 2015 stock market rule. It’s stalled while the rest are up. Why? Partly because the recent months of dollar strength crushed US corporate exports. But mostly because the US stock market posted its gains over the last year. This year, while the FTSE and DAX hit new highs, the US markets are riven by fears of overvaluation and a potential crash caused by the overly strong dollar.

My worry is that the end of the strong dollar could it trigger declines in Europe.

Removing the driver of a weaker Euro could expose the other hopes, including QE’s freeing up banks to lend more, as utterly hollow. It may also persaude global investors to buy the Euro again, expecting it to retrace some of the weakening vs the dollar – dollar longs are getting crushed!

Perversely, the US market is less vulnerable than others to currency strength or weakness. The US economy is capable of internally driven growth, while Europe and Japan clearly aren’t. Because it’s less susceptible to dollar ructions than the Eurozone is to a stronger Euro, it could be that last week’s FOMC dollar stability moment will come back to haunt the Euro yet. 

So what is the trade of the week? Well, we’re short-term nervous on the dollar, but long-term dollar bulls. What about the Euro? What about it…?

Badger