Daily Note – Riding two horses

Riding two horsesSummary:

United States: 10 Year Yields close at a new YTD high on Friday

Eurozone: ECB heads Draghi and Weidmann both give press interview with little new to report.

Portfolio Investment: Long USD Short Euro at 1.3880 targeting 1.32




Good morning from yet another monsoon-like day in Dublin.

It has been bucketing down for days and one of our big Christmas traditions in this city, the annual post Christmas racing festival, has been a bit of a washout, a bit like Liverpool FC’s Christmas campaign.

Despite the weeklong tempest, thousands of Dubliners braved the elements to go racing and this year the appropriately named Hurricane Fly won the big “Ryanair Hurdle” over the weekend. If you want to know where some of the proceeds of your Ryanair airfare go, look no further than Leopardstown racecourse!

But horse breeding is one of Michael O’Leary’s passions; another is Manchester City FC – so he’s on a roll. And now he is becoming contemplative, humane and sensitive- see a piece I wrote for the Financial Times here , who knows you may get the Ryanair yoga retreat in time?

Watching the racing – or more accurately watching a jockey trying to ride two loose horses just after one of the lessor races – got me thinking about the Euro/dollar exchange rate. Well it was more thinking about Ireland and the exchange rate that reminded me of a jockey riding two horses.

Ireland is an economy that rides both the American horse and the European horse.

Ireland’s biggest trading partner is America – via the multinationals – yet our currency is tied to Germany – anchored by the European obsession of our political elite. This means we are much more sensitive to the Euro/dollar exchange rate than any other country in the world.

The best combination for Ireland is a stable, strong dollar because US corporations make more dollar profits here when the euro is weak and, traditionally a weak euro is also a period of low Eurozone interest rates, which helps the local economy.

As a result, the Irish jockey can ride both horses in this stable environment because both horses are moving together in an orderly fashion. But when the horses start going their own way, and the exchange rate is unstable and the Euro is strong, like today, the jockey’s position becomes very uncomfortable.

Consequently, this cross rate is hugely important to the lives of millions of us on this windswept island and therefore, this morning I would like to talk about the prospects for the dollar/euro exchange rate based on what is happening in the US and European economies.

United States: 10 Year Yields close at a new YTD high on Friday

With no data to speak of out of the US on Friday, markets consolidated recent moves. The US 10 year note closed at the key 3% level, having made a new YTD high of 3.02% earlier in the day (see chart below).

Figure 1- Long rates in the US firming

While it is hard to read too much into any moves at this time of the year, this is a key level to watch for the New Year. I believe that  the US will outperform other developed economies in 2014 and the Federal Reserve will continue on the path of “tapering” asset purchase – unless there is a massive sell off in markets which doesn’t look too likely.

For example, US equities continued to power ahead last week. The S&P 500 is up 29% now for the year. Sector divergence is emerging with slow growth sectors like utilities underperforming high growth sectors like materials.

I will have a number of equity market investments in 2014 both long and short; for now though we sit and wait to see how the market develops early in the New Year.

Eurozone: ECB heads Draghi and Weidmann both give press interview with little new to report.

We had interviews with the two chief bottle washers in the ECB over the weekend. These interviews are now a proxy for policy and nothing is said without one eye on markets and the other on politicians.

There was very little new in the interviews but it was somewhat surprising that the Bundesbank head Weidmann seems to be more down beat on the outlook for 2014 than his boss, ECB head Draghi.

Draghi sees no urgent need to cut rates further and no signs of deflation in the Eurozone. Draghi was interviewed in the German news magazine Spiegel on Saturday where he ruled out more rate cuts.

“At the moment we don’t see a need for any urgent action.We are not seeing any deflation at present… but we must take care that we don’t have inflation stuck permanently below one percent and thereby slip into the danger zone.

“The euro zone crisis has not yet been beaten. But there are many encouraging signs including economic recoveries in some countries, easing trade imbalances and shrinking budget deficits.”

Meanwhile, in an interview in Germany’s Bild Zeitung, BUBA and ECB member Jens Weidmann says that while the euro area is currently “in rehab”, calm in financial markets may be short-lived.

He then went on to spew out the usual central banker diet of budget cuts, reform (whatever that means) and better financial regulation – which from the institution that has presided over the delinquent expansion of the German banking sector for the past decade and a half, is a bit rich.

Portfolio Investment: Long USD Short Euro at 1.3880 targeting 1.32

On Friday I published our first portfolio investment. These are ideas that I invest in with my own capital. I am sharing them with you in the hope that it provides some educational help. These are not to be considered recommendations.

In contrast to my positive outlook on the US economy (see my launch note for more), the Eurozone remains mired in economic problems best encapsulated in the chart below.

Figure 2- No lending equals no growth

Bank lending and money supply growth have collapsed and you can’t have economic vibrancy without lending and borrowing.

The great contradiction of the upcoming ECB bank stress tests, is that while these tests are important for the long term credibility of the Eurozone financial system, the tests discourage banks from lending.

Stress tests prompt banks to hoard cash to shore up balance sheets. Now as this unwinds, there could well be opportunity soon in Europe, but for the moment, things are not too kosher.

As we talked about last week, France is a particularly weak link and I believe it will be in recession in 2014.

So why in an environment where Eurozone growth is weak relative to the US, is the Euro up 4.2% against the USD?

The strength of the Euro comes down to one huge structural issue – the massive European current account surplus. See chart (below)

Figure 3- Europe exporting capital when it shouldn’t be

The Eurozone runs a very large current account surplus which is entirely consistent with the collapse in domestic demand and the threats of deflation. Areas run current account surpluses when savings are greater than investments either because the locals are saving too much or prefer opportunities abroad, or both.

Thus European capital is lent abroad and the resulting dividends, rent and interest flows back to Europe, pushing up the Euro. However, the downside of the current account surplus is lower growth at home (where the money is being saved) and greater growth abroad (where the money is being spent and invested).

These growth differentials drive interest rate differentials which move short-term currency flows, as higher yields in one bloc attract cash from the other bloc.

Figure 4- The dollar supported by yields

Interest rate differentials right now suggest the Euro should be closer to $1.25 at the moment rather than $1.38.

While this may be quite extreme it does suggest that in the absence of a significant pick up in growth and bond yields in the Eurozone relative to the US, our bias should be for a lower Euro.

So if the Euro did begin to move lower in 2014 what would be the reaction of the ECB?

While the ECB will backstop a collapse in the Eurozone project, this doesn’t mean it wants a strong Euro. In fact, a much weaker Euro would help countries like Italy whose exporting sector needs a competitive break.

The average for the Euro since inception is around $1.19.

This is my “big picture” view of the Eurozone and on Friday  the market gave me an opportunity to enter this investment at an attractive valuation. As you can see from the short-term chart below the market had a very volatile trading day on Friday.

Figure 5- Euro defying gravity

Traders who took the day off expecting a quiet wind-down to the year may have been badly disappointed.

The euro took flight in European trading, gaining more than 200 pips to almost $1.39. Rumours circulated about Asian central banks and other sources of demand, but once the momentum stalled, fresh shorts piled in nearly wiping out the move and taking the pair back to $1.3740.

Followers of the Twitter handle @globalmacro360 will have seen me place the investment at 1.3860 on Friday morning.

While no investment is ever guaranteed to make money, moves like Friday provide me with an attractive risk/reward profile. I will talk more about the “investment process” in the weeks and months ahead.

Until tomorrow.




The statements, opinions and analyses presented in the articles, newsletters, and other materials appearing on this website are provided as general information and for educational purposes. Opinions, estimates and probabilities expressed herein constitute the judgment of the author as of the date indicated and are subject to change without notice. Nothing contained in this website is intended to be, nor shall it be construed as, investment advice, nor is it to be relied upon in making any investment or other decision. Prior to making any investment decision, you are advised to consult with your broker, investment advisor or other appropriate tax or financial professional to determine the suitability of any investment. David McWilliams shall not be responsible or have any liability for investment decisions based upon, or the results obtained from, the information provided.

Categories: Daily Note