26.01 Weekly Viewpoint : The strength of the euro is a side effect of the weakness of the dollar.

Such weakness is inconsistent with the trend of interest rates and the upward revision of growth estimates……

Such weakness is inconsistent with the trend of interest rates and the upward revision of growth estimates. On the other hand, it may reflect the perception that the current US administration welcomes a weaker dollar as functional to its mercantilist policies. The ECB has tried to soften the tones of its communication, albeit without questioning expectations for a normalisation, already priced in by the market.

Starting in mid-December, the EUR/USD exchange rate appreciated by 5.7%. As in the past few weeks expectations referred to European policy rates also strengthened, many could be tempted to read this movement as a side effect of monetary policy developments. However, the effective exchange rate of the euro only rose by 2% in the same period, whereas the dollar’s effective exchange rate slipped by 5.5%. Therefore, we have been witnessing a plunging dollar in currency markets, rather than a strong euro. The dollar has shed ground against the yen, the renminbi, the Brazilian realm and pound sterling. This state of affairs is not so simple to explain. The 2Y swap rate differential, typically a good proxy of the exchange rate trend, would have suggested a movement in the opposite direction, towards 1.05. Effectively, expectations referred to fed funds rates have increased, and with them, the dollar rate curve. However, all considered, there is still at least one full year to go of divergence between short-term rates on the dollar and on the euro. Previous phases of exchange rate dislocation compared to rate differentials materialised in 2009 and 2014-15: in both cases, they were ended by the exchange retuning towards levels compatible with rate differentials, albeit after one year, and in the latter case, giving rise to opposite excesses (dollar too strong compared to differentials in 2015). 

Three factors are playing against the dollar, at the theoretical level: trade imbalances, changes in the composition of currency reserves, and the attitude of the Trump administration on exchange rates. Closing the trade imbalances would require a realignment of the dollar by around 10%, all other conditions being the same; however this has never been a reliable indicator of the trend of the US currency. The replenishment of currency reserves could be encouraged by the United States’ more aggressive foreign policy, although it is hard to say whether this has truly played a crucial role in the recent phase. On the other hand, there is surely a mounting perception that the present US administration could welcome a weaker dollar to be able to present electors with a smaller trade deficit in a few years’ time, despite statements to the contrary made by Trump in Davos. This may limit the dollar’s potential upward correction driven by rate differentials and profit-taking on short speculative positions against the US dollar.

The ECB has reacted to the movement of the exchange rate by criticising the unorthodox statements made by US Treasury Secretary Mnuchin, but also by softening the tones of its communication. The statement issued following the Governing Council meeting on Thursday indicates that the recent movement of the exchange rate is an element of uncertainty which risks undermining the return of inflation to target in the medium term. Draghi has said that if the exchange rate remains strong at length, the ECB could reconsider its monetary policy strategy. Furthermore, he also tried to discourage any expectations for an acceleration of the normalisation process (signals of an acceleration in wages and domestic prices remain bland and unconvincing, and call for still markedly accommodative financial conditions, he said) and sought to downplay the differences in opinion among Governing Council members. However, expectations are still strong for the asset purchase programme to be closed by the end of the year, with guidance on rates subsequently undergoing changes to set the stage for a return of interest rates into positive territory in the course of 2019.

FOMC: waiting for inflation

The January FOMC meeting is not expected to bring developments on the monetary policy front, confirming the positive assessment of the growth outlook and the projected gradual inflation pickup, compatible with an ongoing path of gradual rate hikes. 

The mix of solid growth and moderate inflation at the center of the Fed’s scenario could be hit by the effects of growing political tensions in Congress, brewing through the spring (appropriations bill, debt limit, NAFTA). Moreover, the outlook could be shaken by the recent focus of the White House on trade, with a strong protectionist tilt and conflicting messages on the dollar. The FOMC likely will not show explicit concern but, in the minutes, may acknowledge the presence of renewed uncertainty, even after the approval of the tax reform.

The change in the Fed’s leadership and the introduction of many new members, both on the Board and among regional Fed presidents, starting in February, is not expected to significantly alter monetary policy management, although it may marginally tip the balance of power within the Committee to the advantage of hawks.

The week’s market movers

In the Eurozone, the EU Commission’s ESI, and the Istat business confidence index, should confirm that economic activity is continuing to increase unhindered at the beginning of 2018. The flash estimate for 4Q should outline a slight slowdown in euro area GDP growth, to a 0.5% q/q from un previous 0.7% q/q in estate, mostly in the wake of a temporary moderation in Germany to 0.6% q/q from 0.8% q/q and in Italy to 0.2% q/q. In France, GDP growth is seen stable at 0.6% q/q. The Spanish economy is estimated to have entered a more “normal” growth phase (0.7% q/q), after booming in the past year. Market focus will be more on flash inflation estimates for January than on the trend of GDP at the end of 2017. Advance estimates should outline a decline in euro area inflation to 1.1% in January, from a previous rate of 1.4%, due to an unfavourable statistical effects tied to the energy component, offset only in part by the recent rise in oil prices. Harmonised inflation is expected to increase in Germany to 1.7%, while declining in France to 1.1% from 1.2%, and by almost one percentage point in Spain to 0.3% from 1.2%. In Italy, inflation is forecast unchanged at 1.0%.

Busy week in the United States in terms of data releases and events. The FOMC meeting is not expected to change the monetary policy outlook, and the possibility of a further rate hike soon should be confirmed, based on a positive assessment of the growth trend, and on the forecast gradual recovery in inflation. Among the January data, the ISM manufacturing index is expected to keep pointing to positive growth; the Employment Report should be supportive, outlining solid job growth and a possible further drop in the unemployment rate; consumer confidence is expected to stay high and at levels compatible with solid consumption growth. As regards December data, personal spending and personal income should be up, while the core deflator is expected to increase by 0.2% m/m; construction spending should mark a fifth consecutive rise.

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