Tuesday, September 9th, 2014

Panic Button

The great thing about most central bank decisions, particularly those of the ECB, is not to panic if you don’t understand what has been decided. Central bankers have a duty to explain, not least to their political masters, but also to financial markets. If the markets don’t understand what they are trying to achieve, it almost certainly won’t happen. Last week’s announcements from the ECB were not QE, because that still is beyond its powers, but they were as close as they felt they could go, a sort of “QE-lite”.

So the question is do the markets understand? We believe the answer is mostly yes. Hence there is no rush to upgrade GDP forecasts for the Eurozone, because most analysts still think that the transmission mechanism between policy and the real economy is ineffective. The banking system is still in deleveraging mode in advance of the ECB stress tests, the results of which are due to be announced in October. And that’s means net lending to the non-financials sector will remain subdued.

But FX markets have moved a lot. Having touched 1.40 as recently as May, the EURUSD is now down to 1.28 and shows no sign of stopping. This matters because most econometric models show that the Eurozone economy is about three times more sensitive to effective exchange rates than it is to fiscal or monetary policy, but as with all FX interventions, there is a long time lag.

In the short term there are three main investment consequences. First, euro-denominated equities become deeply unattractive to non-European investors unless the currency exposure is fully-hedged. Second, there is a powerful contagion effect on all other European equity markets, which are forced to confront the reality that GDP growth in their main export market is so weak that it requires emergency measures. Third, US investors either stay at home or shift their international diversification efforts to Japan and the rest of Asia. Our country allocation models suggest that all three are happening at once. This is very simple, but sometimes simple is good.

However there is a risk case. In recent months we have often drawn the parallel between the Eurozone and Japan. What if Q3 2014 in the Eurozone is like Q4 2012 in Japan? What if the exchange rate, not monetary aggregates, is the real target of ECB policy? This can only work if the country on the other side of the exchange rate agrees (or at any rate acquiesces) to the policy. Between October 2012 and May 2013 USDJPY went from 78 to 103, equivalent to a depreciation of over 30% and nobody in the US Treasury or Congress complained. Investors took the hint, and the Japanese equity market soared, with a lag of about two weeks.

So far the euro has depreciated by about 9% against the dollar. Nobody in the US has said they agree with the new exchange rate, but nobody has said they don’t. If this is a repeat of 2012/2013 the EURUSD could eventually get as low as 1.10. If that happens, even the Eurozone economy might manage to produce respectable growth in 2016, and Eurozone equities would have to respond.

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