Article / 16 August 2017 at 10:00 GMT

Macro Digest: Dollar liquidity, Draghi to cap EURUSD? — #SaxoStrats

Chief Economist & CIO / Saxo Bank
  • EURUSD above 1.18 ' a medium-term sell'
  • Strong euro hurting European exporters, growth
  • Emerging markets 'may have peaked for now'

Jackson Hole, Wyoming
Jackson Hole, Wyoming: ECB chief Mario Draghi's decision not to weigh in on policy at the August 24-26 summit could mean he is biding his time before deciding on the strong EUR, inflation, and the central bank's next move. Photo: Shutterstock

By Steen Jakobsen

Has the strength of the euro become a real issue for the European Central Bank and growth in the European Union? In our view, we are close to that point. We expect ECB president Mario Draghi and the central bank as a whole to start warning about the “speed of the move” and slowly but gradually pricing out further Federal Reserve hikes as US inflation is subdued at best... and falling at worst. 

Both internal and external factors are slowing while the broader economic data are coming off. This “normally” leads to the ECB raising the yellow and ultimately the red flags, hence we feel that EURUSD above 1.1800 is a medium-term sell. This also coincides with a rising “financing” cost and a shortage of US funding dollars.

Bias: Short EURUSD with two-day close above 1.1950 as a stop.

We have been very constructive on the euro since early this year based on the economic pickup our models registered through 2016 into 2017. Before the French election, we were very isolated in this view (see Bloomberg for an analysis of our stance), and after the French election we pointed out that European equities had probably peaked

The market and technicals indicate that 1.2000 is in reach, however we will go neutral here on both the euro and the US dollar after a considerable time of “selling it”…

Draghi will not do a “Trichet” and hike rates, nor will he even normalise before end of his term. No one has heard from (2003-11 ECB head Jean-Claude) Trichet since his departure, and Draghi does not want a similar fate. 

Draghi’s term ends October 31, 2019.

Furthermore there are now clear signs that the strong euro is hurting European exporters and growth...
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Source: Saxo Bank

The STOXX 600 index peaked in May and is testing support levels right now. Since French president Emmanuel Macron’s election in May, the European stock market (despite massive flow and momentum support) has relatively trailed the US stock market as illustrated below. 

(Indices both indexed to 100 as of end of April.)

Source: Bloomberg
Here are the S&P 500 and the STOXX600 Index at 100 as of April 30, just after the French election).

One further reason for some concern would be the “relatively” tighter monetary conditions...
Financial conditions
Source: Bloomberg

Although conditions are easy, there has been a big swing (minus 40 basis points) since the last ECB meeting.

On the dollar side, my good friends at Nedbank, Neels Heyneke and Mehul Daya, do some of the best work on dollar liquidity...

Dollar liquidity
This chart looks at how the “debt ceiling” can become a real issue for “excess dollars” – Neels and Mehul expect the risk-on phase could be replaced by risk-off as the deadline draws closer. 

Similarly, the currency swaps have reversed from easy to less easy; this is best represented by the one-year basis swaps for JPY.

Currency swap
The steep trend towards “plenty” of liquidity seems to have reversed.. 
Finally, the more boring data (economics) also indicate that the impressive run in European growth is fading. This can be seen below in Citigroup’s Surprise Index and the 10-year bond spread between Germany and Italy/Spain (it’s small, but it has reversed) .

Economic surprise
Source: Citi

Source: Saxo Bank

Finally, this chart courtesy of Saxo Privatbank chief investment officer Theis Knuthsen is interesting. These levels of European High Yield have “mean-reverted” sharply higher.

The upcoming calendar event is below. Today it was announced that Draghi will not talk policy at the Fed's Jackson Hole summit (August 24-26), which indicates he is biding his time to make a decision on the euro, inflation (or not), and his next move.

The data, meanwhile, continue to deteriorate indicating that now is the time to go square and wait for the next impulse.

The one single risk, if we’re right, is that emerging markets may have peaked for now. We know that US is everything in terms of direction; much of this year's performance in risk-on has been driven by ample USD liquidity (as shown above) as well as the negative convexity play by desperate investors chasing equity return in risk parity and exchange-traded funds.

We are now neutral EM looking to time a big short into a dollar liquidity shortage into (in turn) the looming debt ceiling at the end of September .

Emerging markets
Source: Bloomberg

Conclusion: EUR, dollar, EM, and risk-on are a few weeks away from their lows (or highs). Liquidity (less) and credit impulse (less) will start to exert financial gravity by the end of August going into September. 

— Edited by Michael McKenna

Steen Jakobsen is chief economist and CIO at Saxo Bank


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