Positioning portfolios for the rise of the euro
As US and European monetary policy divergence reaches a peak in coming months, we are positioning portfolios for the rise of the euro – the next major trend we see in foreign exchange markets.
Head of Investments, Lombard Odier Private Bank
Central banks in a fix
With economies growing above-trend and labour markets tightening in the US and Europe, monetary policy is gradually turning more restrictive. But with inflation remaining subdued, central banks are in a quandary. Both the US Federal Reserve (Fed) and the European Central Bank (ECB) are considering what the right policy mix should be.
The Fed – in active mode
The Fed remains the most active central bank in developed markets today, gradually but actively unwinding extraordinary policy measures and raising interest rates. At its June meeting, the Fed raised rates for the third time in seven months, bringing the Fed funds rate to 1.25%. Its future growth and monetary policy projections were left broadly unchanged, implying a fairly steady pace of rate rises over the coming years, and one more hike in 2017.
Yet US inflationary data (which fell between the Fed’s March and June meetings) points in a different direction to developments in the real economy and labour markets (which signal above-trend growth is continuing). Unless inflation picks up, we think the Fed’s ability to continue hiking will come into question as rates enter the 1.5-2.0% range. The standard ‘Taylor rule’, which links the path of interest rates to developments in price growth and labour markets, implies rates should be curbed around 2%. The Fed is also limited by interest rates on its long-dated debt, since any move above 2% might invert the yield curve.
This is partly why the Fed’s focus has shifted to its balance sheet, which ballooned following post-financial crisis quantitative easing. At its June meeting, Fed Chair Janet Yellen announced this would be shrunk “relatively soon,” by allowing some securities it holds to mature each month. If the process starts later in 2017 and continues uninterrupted according to the Fed’s plan, we expect its balance sheet to shrink by about 1 trillion US dollars (USD) by late 2020, which should also modestly tighten monetary policy.
Caution from the ECB
The ECB has been more cautious than the Fed in unwinding post-financial crisis extraordinary measures. It has a four to five-year time-lag on its US counterpart, and faces a much more complicated route to normalisation (for instance, the Fed never sent rates into negative territory). But while ECB policy remains in ‘crisis mode’, Europe’s economy is in rude health. Second quarter eurozone purchasing manager index (PMI) figures indicate the best quarter in six years, unemployment is at an eight-year low, and German business confidence hit a record high in June . Political risk has stabilised – albeit concerns remain in Italy – and spreads between German Bunds and yields in peripheral Europe have narrowed. Eurozone real gross domestic product (GDP) growth is running at around 1.9% annually and inflation at around 0.9%. With nominal growth close to 3%, rates at -0.4% look incongruous.
The ECB dropped its previous reference to possible further rate cuts at its 8 June meeting, shifting policy by fractions of a degree. At a speech on 27 June, President Mario Draghi shifted the rhetorical tone further, noting that “deflationary forces have been replaced by reflationary ones” and that “all signs point to a strengthening and broadening recovery in the euro area.”
In our view, the ECB will likely announce the removal of unorthodox policies - including the gradual shrinking of its asset purchase programme - in September or December 2017, and start implementing them in early 2018. We foresee the bank first slowing monthly asset purchases from 60 billion euros (EUR), to EUR40bn, EUR 20bn, and zero, then raising rates from -0.4%, to -0.2%, and 0%. The process could happen in several stages and last 12-15 months, with unorthodox policies ending in late 2018 or early 2019.
A tipping point in markets
We believe that at some point in the next six months, markets will reach an inflection point where monetary policy divergence between the US and Europe will peak. As the ECB turns more restrictive in 2018, we expect Fed policy to have reached a ‘terminal value’ between 1.5-2.0%, and the Fed to be struggling to reduce its balance sheet. We expect ECB balance sheet normalisation to provide a boost for the region’s banks, and to cause few major problems for markets, taking its lead from the smooth reaction to the Fed’s well-signalled path towards normalisation.
But the most radical moves, we believe, will be felt in foreign exchange markets, with the EUR rising against the USD. We believe the EUR’s fair value versus the USD on a purchasing-power parity basis to be around EUR1.21. However, we note that markets often overshoot, and that EUR/USD could climb as high as 1.30 in the next 12-18 months.
The ECB’s actions will also affect monetary policy beyond the euro bloc. We expect the Swiss National Bank and the Swedish Rijsbank to tighten rates after the ECB has started, lessening the chance of a divergence in their respective exchange rates. Against sterling, we note that the picture is more complex, and highly conditional on the direction that Brexit negotiations take. That said, a softening UK economy, a weak government, and substantial twin budget and external deficits could continue to weight on the pound, making further depreciation against the euro seem likely in the months ahead.
Positioning portfolios for the rise of the euro
We have already started positioning portfolios to benefit from the peak in US and European monetary policy divergence, by reducing USD exposure. Should the trajectory of monetary policy and economic scenarios continue along the lines we foresee as 2017 progresses, we could reduce this further in coming months.