After losing virtually all influence over the euro-dollar exchange rate since the beginning of last year, interest rate differences seem to be making a comeback, in the wake of rising oil prices. If renewed sensitivity continues, it could have a profound impact on exchange rates. If the euro-dollar exchange rate pair normalized with respect to its long-term reaction function, the economic conditions currently prevailing in the United States and Europe would imply a euro below parity with the dollar.
Until recently, however, the reaction function did not hold sway. It was weakened by structural deterioration in the outlook for the US economy, and many economists who believed in these models were caught unawares all through last year. With this in mind, let’s examine whether rising oil prices could normalize the situation and push the dollar higher, and as a corollary, the euro lower.
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This week’s figures from the US Energy Information Administration (EIA) seem to have stopped traders speculating on rising prices in an overheating oil market. Lower inventories, higher production and lower US imports raised doubts about whether the current oil price is fair, after market euphoria in the last few months took it from $46 per barrel on average in June to over $71 on 25 January. The price of Brent North Sea crude, which had been wavering since the previous weekly report, gave way after Wednesday’s figures and seemed on track to end the week below $64.
Bond yields have barely responded to the move so far. However, that may not last if, as we expect, oil prices keep falling and drag metals down with them, since the rise in metals prices in the last few months has little fundamental justification.
If our scenario proves correct, that would seriously change the context, affecting inflation expectations, bond yields, the forex market and the relative performance of emerging markets and individual sectors. Overall, there is a significant risk that developments seen in the last few weeks will reverse as quickly as they occurred.
Although such adjustments could reduce the downward pressure on indexes resulting from fears that interest rates will rise too quickly, they would definitively rule out the reflation scenario that the markets have been overwhelmingly backing since mid-December. In the best-case scenario, this could stall the correction, without necessarily pushing markets back up to their recent highs.
English translation by trafine
Summary – Current economic trends seem particularly favorable, but after taking a step back, we are inclined to be more circumspect than the consensus of economists on the outlook for 2018. Our worldwide scenario has changed little since September. Our global GDP growth forecast for 2017 remains the same, at 3.6%, and we have lifted our 2018 scenario slightly to 3.3% from 3.2%. Upward revisions to our 2017 estimates for the developed world offset the declines we project in emerging markets. Meanwhile, we continue to foresee a modest global slowdown in economic activity next year as a result of reduced US and Chinese growth.
In this context, and amid the structural changes underway, worldwide inflation does not look ready to accelerate. It should fall from 2 % on average this year to 1.8% next year, in the wake of declining raw material prices. With no inflation on the horizon, central banks will maintain their very accommodative bias. Restricted by a persistent flat yield curve, the Fed will have trouble carrying out the three key interest rate increases it has planned. The ECB will remain particularly conservative and is unlikely to have an opportunity to take a position on a future increase in key rates.
The dollar is set to disappoint and maintain pressure on other countries. Japan, now benefiting from a more promising environment, is probably the country best placed to absorb the market’s wariness with regard to the US currency. Our exchange-rate scenario remains unchanged from our September projections and includes a substantial appreciation in the yen.
In the short run, we think exposure to risk is still a viable strategy, so long as it is focused on developed markets. But the current environment requires investors to be ready to change direction at a moment’s notice. For this reason, we have developed a fundamental allocation to complement our short-term, tactical recommendations.
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The main risk from the FOMC’s meeting in the past two days was a possible change of direction on Fed monetary policy. It looks like the bank is staying the course. Today’s statement was unequivocal: there will be no rate hike in the foreseeable future. We can only tip our cap to the Fed’s determination in resisting mounting pressure from the market. Janet Yellen would be taking an imprudent risk if she were to rise to the bait and hint at a possible rate hike. Indeed, the U.S. economy may be doing better than it was a few months ago but its ability to weather an increase in long-term interest rates, which would be the obvious corollary to anticipations of a rate hike, is, in our opinion, close to nil….even after apparently positive GDP numbers from the second quarter.
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6%, the hypothetical differential with EMU 17 nominal interest rates required by Latvia to accompany its economic convergence over the next quarter century
+ 6: That’s how many countries have joined the European Monetary Union since 2007. At the rate we’re going, the EMU could expand from 18 to 25 members within ten years, or even more—unless, of course, it sheds a few and actually shrinks. But who’s to know, and how to know, where such a deeply dysfunctional currency bloc is heading?
We’d love to share the enthusiasm (however perfunctory) that customarily surrounds the addition of a new eurozone member. We’d rather not be criticizing what looks like a mad scramble to glue together a steadily rising number of countries that stand next to no chance of functioning properly under the same interest rate—the ECB’s. Unfortunately, we can’t help sensing that Latvia will eventually be going the same road as Greece, Ireland, and Spain. If it does, it won’t be due to mismanagement, as some pundits may fear. It will happen because even with the best of intentions, the Latvians will be powerless to offset the impact of a monetary policy that is inherently unsuited to their situation.
Latvia’s EMU membership offers a good opportunity to step back and focus on a crucial underlying issue often overlooked by economists: fast-tracking insufficiently developed economies into the currency bloc is irresponsible policy (for a slightly different treatment, see our article of July 2012, “From High Hopes to Despair: The Missing Metric in the European Monetary Union”).
Why such a harsh judgment? Because the record shows that economies can’t converge after joining the EMU; they have to do it beforehand.
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New round of central bank liquidity injections worldwide
- The U.S. economy can’t do without Fed support
- The euro area is out of recession, but bank sector and sovereign issues remain
- The Fed, BoJ, BoE and ECB continue to nurse ailing economies
Continued low interest rates are not enough to dispel emerging risks
- The momentum driving global trade has been undermined for the foreseeable future
- China can no longer act as the global engine of growth
- Foreign exchange rate adjustments appear inevitable
Is inflation, end-point of the financial crisis, around the corner?
- New round of liquidity injections, currency crises, geopolitical tension, labor unrest…
- … Inflation remains the most likely scenario, but the path ahead is unclear
If we’re correct in assuming the Federal Reserve is not about to start scaling back its asset purchases, worldwide liquidity injections should hit a new high next year. Whereas the aggregate balance sheet of the four leading central banks showed little change in the first half of 2013, we can expect widespread central bank activism over the next few quarters:
- At a rate of 85 billion dollars a month, the Fed’s asset purchases should amount to 1.02 trillion dollars a year.
- The Bank of Japan will be adding anywhere from 600 to 718 billion dollars to its balance sheet as it strives to meet its target of expanding Japan’s monetary base by between 60 and 70 trillion yen a year (making it some 40 percent larger than at the beginning of 2013).
- The Bank of England will be buying 610 billion dollars’ worth of Gilts in connection with its objective to purchase 375 billion pounds of assets via its Asset Purchase Facility.
- The ECB’s probable upcoming LTRO is likely, in our estimate, to provide Europe’s banks with between 250 and 500 billion euros, or 350 to 750 billion dollars.
The “Big Four” should thus be injecting a cool 1.6 to 2.5 trillion dollars into the system in annual terms (at a pace of 135 to 208 billion a month). This should continue, if not throughout 2014, then at least through the early part of the year. In the low-case scenario, that would equal 10 percent of American GDP; in the high-case scenario, it would equal almost the entire size of France’s economy in 2012! But whether the ECB follows suit or not, the annual flow of fresh liquidity should return to the highs seen in 2011 and 2012—and for the ECB’s LTROs, could even set a post-2008-crisis record.
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The recession in the euro area is almost officially over, but that doesn’t mean the economy is back to normal—far from it. As long as no structural growth policies are enacted, the outlook for the EMU will remain grim and member states will have as much trouble meeting their fiscal targets as before. This leaves just two options open. Either Europe reverts to austerity—in which case the recovery will collapse and we’ll be in for another slump with highly unpredictable consequences—or the ECB completely overhauls its policy stance. The latest developments in the international arena make this second option increasingly likely.