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.
The financial analysts who prepared this report, and whose names and roles appear on the first page, certify that: (1) The views expressed on companies mentioned herein accurately reflect independent, fair and balanced personal views; (2) No direct or indirect compensation has been or will be received in exchange for any views expressed. Specific disclosures: The analysts who prepared this report do not receive bonuses, salaries, or any other form of compensation that is based upon specific investment banking transactions.
This research has been prepared by Intesa Sanpaolo S.p.A. and distributed by Banca IMI S.p.A. Milan, Banca IMI SpA-London Branch (a member of the London Stock Exchange) and Banca IMI Securities Corp (a member of the NYSE and NASD). Intesa Sanpaolo S.p.A. accepts full responsibility for the contents of this report. Please also note that Intesa Sanpaolo S.p.A. reserves the right to issue this document to its own clients. Banca IMI S.p.A. and Intesa Sanpaolo S.p.A. are both part of the Gruppo Intesa Sanpaolo. Intesa Sanpaolo S.p.A. and Banca IMI S.p.A. are both authorised by the Banca d’Italia, are both regulated by the Financial Services Authority in the conduct of designated investment business in the UK and by the SEC for the conduct of US business.
Opinions and estimates in this research are as at the date of this material and are subject to change without notice to the recipient. Information and opinions have been obtained from sources believed to be reliable, but no representation or warranty is made as to their accuracy or correctness. Past performance is not a guarantee of future results. The investments and strategies discussed in this research may not be suitable for all investors. If you are in any doubt you should consult your investment advisor.
This report has been prepared solely for information purposes and is not intended as an offer or solicitation with respect to the purchase or sale of any financial products. It should not be regarded as a substitute for the exercise of the recipient’s own judgement.
No Intesa Sanpaolo S.p.A. or Banca IMI S.p.A. entities accept any liability whatsoever for any direct, consequential or indirect loss arising from any use of material contained in this report.
This document may only be reproduced or published together with the name of Intesa Sanpaolo S.p.A. and Banca IMI S.p.A.. Intesa Sanpaolo S.p.A. and Banca IMI S.p.A. have in place a Joint Conflicts Management Policy for managing effectively the conflicts of interest which might affect the impartiality of all investment research which is held out, or where it is reasonable for the user to rely on the research, as being an impartial assessment of the value or prospects of its subject matter. A copy of this Policy is available to the recipient of this research upon making a written request to the Compliance Officer, Intesa Sanpaolo S.p.A., 90 Queen Street, London EC4N 1SA.
Intesa Sanpaolo S.p.A. has formalised a set of principles and procedures for dealing with conflicts of interest (“Research Policy”). The Research Policy is clearly explained in the relevant section of Banca IMI’s web site (www.bancaimi.com).
Member companies of the Intesa Sanpaolo Group, or their directors and/or representatives and/or employees and/or members of their households, may have a long or short position in any securities mentioned at any time, and may make a purchase and/or sale, or offer to make a purchase and/or sale, of any of the securities from time to time in the open market or otherwise. Intesa Sanpaolo S.p.A. issues and circulates research to Qualified Institutional Investors in the USA only through Banca IMI Securities Corp., 245 Park Avenue, 35th floor, 10167 New York, NY,USA, Tel: (1) 212 326 1230. Residents in Italy: This document is intended for distribution only to professional investors as defined in art.31, Consob Regulation no. 11522 of 1.07.1998 either as a printed document and/or in electronic form. Person and residents in the UK: This document is not for distribution in the United Kingdom to persons who would be defined as private customers under rules of the FSA.
US persons: This document is intended for distribution in the United States only to Qualified Institutional Investors as defined in Rule 144a of the Securities Act of 1933. US Customers wishing to effect a transaction should do so only by contacting a representative at Banca IMI Securities Corp. in the US (see contact details above).
Trading Ideas are based on the market’s expectations, investors’ positioning and technical, quantitative or qualitative aspects. They take into account the key macro and market events and to what extent they have already been discounted in yields and/or market spreads. They are also based on events which are expected to affect the market trend in terms of yields and/or spreads in the short-medium term. The Trading Ideas may refer to both cash and derivative instruments and indicate a precise target or yield range or a yield spread between different market curves or different maturities on the same curve. The relative valuations may be in terms of yield, asset swap spreads or benchmark spreads.
Coverage Policy And Frequency Of Research Reports
Intesa Sanpaolo S.p.A. trading ideas are made in both a very short time horizon (the current day or subsequent days) or in a horizon ranging from one week to three months, in conjunction with any exceptional event that affects the issuer’s operations. In the case of a short note, we advise investors to refer to the most recent report published by Intesa Sanpaolo S.p.A’s Research Department for a full analysis of valuation methodology, earnings assumptions and risks. Research is available on IMI’s web site (www.bancaimi.com) or by contacting your sales representative.