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Diagnosing the Declining Euro - Global Exchanges

FICC Podcasts November 16, 2021
FICC Podcasts November 16, 2021

 

In this week's episode, we discuss the recent drop in the Euro along various crosses.

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About Global Exchanges

BMO’s FX Strategists, Greg Anderson and Stephen Gallo, offer perspectives from strategy, sales and trading on the foreign exchange market, related financial markets, and the global economy.

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Greg Anderson:

Hi, welcome to Episode 25 of Global Exchanges, a podcast about foreign exchange markets and related issues. I'm Greg Anderson. In this week's episode my co-host, Stephen Gallo, and I will be talking about the recent drop in the Euro along various crosses. The title for this episode is "Diagnosing the Declining Euro".

Stephen Gallo:

Hi, I'm Stephen Gallo, a London-based FX strategist. Welcome to Global Exchanges, presented by BMO Capital Markets.

Greg Anderson:

Hi, I'm Greg Anderson, a New York-based FX strategist. I'm Stephen's co-host.

Stephen Gallo:

In each weekly podcast like today's, we discuss our perspectives on the global economy and the foreign exchange market. We also bring in guests from the FX industry and from related financial markets, like commodities.

Greg Anderson:

We strive to make this show as interactive as possible, so don't hesitate to reach out by going to bmocm.com/globalexchanges. Thanks for joining us.

Speaker 3:

The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries.

Stephen Gallo:

Okay. For the record, it's November 16th, 2021. As Greg said, this is episode 25. Greg, so I got to ask you, what specific highlights do you have for us?

Greg Anderson:

The number one feature in the FX market this week, that we pretty much have to highlight, is Euro weakness. I'll start with the obvious, Euro dollar. Just last week, support at 1.15 the figure looked pretty solid, but it went quickly this week and we just dived through 1.14.

Greg Anderson:

And where a number of currencies, and especially Canadian dollar, were trading in tight correlations with the Euro against the U.S. Dollar. Most of these non-European currencies did not follow the Euro lower. So as a result, a support broke in Euro CAD. And we're now looking at a new low since 2017. Also in Euro China, we're at a low since 2017 and even intra Europe crosses the Euro is under pressure. With support at 1.05 the figure in Euro Swiss looking wobbly and Euro Sterling headed back down to where it was before the bank of England, disappointed by not raising rates a little under two weeks ago. So Steven, you provide our primary coverage for Euro. I'm delighted to say that this Euro move means you're primarily on the hot seat this week. Are you ready for that?

Stephen Gallo:

Yeah, that's fine, Greg, for a short while, I'll go with that.

Greg Anderson:

When we talk about Euro dollar, usually the number one factor to discuss is relative monetary policy. And that is ordinarily put into a number through some tenor of interest rate differential. So to kick off, is the two year interest rate differential, or perhaps more broadly relative monetary policy responsible for this week's downdraft in the Euro?

Stephen Gallo:

Greg, in the case of Euro dollar, the currency pair, I definitely think shorter duration interest rate differentials have mattered. And although there hasn't been a dramatic move in relative yields this week, the two year swap rate differential has been steadily drifting against spot Euro dollar for about two months, I'd say. One relationship that I've been flagging for most of the second half of the year, and been throwing into charts in various publications has been Euro dollar spot inverted overlaid with the implied rate differential between the June, 2023 Euro dollar contract and the June, 2023 Euribor futures contract. And that differential, interestingly, hit a cycle high of 134 and a half basis points today. Now remember, we're to talking about the rates markets expectations a little under two years out, and anything can change by then. But to answer your question, yes, expectations for Fed and ECB, monetary policy diversions and rate differentials haven't been helping Euro dollar. If anything, I'd say they've been weighing on the currency pair.

Greg Anderson:

So five weeks ago we did a podcast called Euro Out of Gas. That was our last deep dive into the Euro. At that time, natural gas prices for delivery in places like the Netherlands and Germany were spiking. In that podcast, I introduced the Bloomberg ticker code T T F G D A H D. That is a ticker for the price of next day delivery. Natural gas in the Netherlands. At that time, this price was in the middle of a massive spike. So my question, Steven, has that spike gotten worse and is this responsible for this week's Euro decline?

Stephen Gallo:

Greg, you know, as with rate differentials, is I think this is a factor which certainly has not helped the Euro. So energy prices remain higher, overall, we know this. And certainly they're above well above their year ago levels. And when I look at the ticker, you specifically mentioned on Bloomberg, which is one measure of European natural gas prices, we've had to move up this week in the price and it's now within reach of its mid-October level. So I think there are two distinct Euro negative factors here, Greg. And we touched on both of them in the podcast you mentioned. One is the hit to the external account from high energy prices. The other is the medium term energy security risk discount in the Euro, given the EU relatively high energy import dependency ratio. Germany in particular has a high dependency ratio and it's above the EU average.

Greg Anderson:

Hey Steven, when you talk about Europe's energy security, it's not just about dependency on foreign sources. It's also about who those foreign sources are. So on that note, when NAI seated in the US, do a search for news about Europe, the number one thing that comes up is this issue of Russian troops, supposedly amassing at the Russia Ukraine border. I would think something like that would probably put a geopolitical risk discount into the Euro. So is that a factor behind the weakness in the Euro this week?

Stephen Gallo:

The answer is yes, Greg. The source of the natural gas supply is a key energy security issue for the European union, especially with EU climate policy aiming for a relatively rapid reduction in emissions by the end of this decade. And what that has done is put a premium in the price of less dirty hydrocarbons, like natural gas. Incidentally, the front month carbon permit futures price in the EU hit another record high above 67 euros per ton of CO2 today, Greg. So that's part of the situation, but into that mix, we've also got to add an internal political risk discount into the Euro because of disputes between Brussels and Poland over the rule of law. And now we've got a geopolitical one due, due to a spat between Brussels and the government of Belarus over the issue of mass migration at the EU's Eastern frontier. It's also sort of looking pretty pear shaped at the moment, Greg.

Greg Anderson:

One of the things that you often talk about, Steven, is Europe's competitiveness problems. I know it's not new news really, but is it possible that the FX market has become more focused on the competitiveness issue this week? And that is behind Euro weakness?

Stephen Gallo:

Greg, that's not a bad shout. Yes, I think quite possibly. Let's just reexamine the September trade balance figure for the Euro area, which was released on Monday. In seasonally adjusted terms, the merchandise trade surplus came in at about 5 billion euros below expectations. So the surplus was 6 billion euros for the month of September. And just to put things into perspective, the pre pandemic peak for the goods trade surplus was 27 billion euros. So that's an enormous decline, but you know, let's look at the bigger picture and the bigger picture, the value of imports is much further above its pre pandemic level than the value of exports. And that's a good way of seeing the extent to which higher import costs have eaten into the Euro areas trade surplus.

Stephen Gallo:

Now some of this is short term cyclical, but I think because financial markets are very forward looking, we need to be asking the question "Will Germany and the Euro area be able to leverage the positive forces of globalization in the years ahead, the same way they did the pre pandemic and pre global financial crisis?" That's definitely an open question. You know, in other words, do we need to get used to the Euro area running smaller trade surpluses than it has in the past?

Greg Anderson:

Okay. So we've built a pretty long laundry list of relatively new reasons for being bearish on the Euro. And we've only moved from call it the low 1.15's To the low 1.13's in Euro dollar over the past week or so. Is that enough? What's out there to stop Euro dollar from making a quick move to 1.10 before or year end, Steven?

Stephen Gallo:

Well, positioning, leverage funds are already quite short of euros on a number of axis, Greg. So positioning is something that can slow the move down in the Euro. I've got to flag the ECB factor just simply because it's so obvious. It's possible that the ECB might have to step in verbally or further reduce the pace of its asset purchases at the December ECB rate decision. But it's so firmly nailed its colors to the mass in terms of its dovishness. I think there's only so much you can do in that regard. Honestly, Greg, I think that for the Euro decline to reverse, we really need to see the focus shift back to some type of negative factor for the US dollar. It's really time for me to get out of this hot seat, Greg. So is there anything that we should be looking at in terms of a downside risk factor for the dollar?

Greg Anderson:

I'll start with what you mentioned, positioning. The FX market is pretty darn long USD against everything, not just Euro. And with year end approaching, one would think that we'd see positioning reductions and a bit of dollar downside related to that. But on top of positioning, the other thing I will point out is the Fed share decision. There was a Bloomberg article out earlier today saying that the decision is "imminent". Color on me, skeptical on that, but that would, I think that we get the announcement by the end of November anyway, and perhaps sooner. The latest in the predicted futures market is an implied probability of about 70% for Powell and 30% for Lael Brainard. We've been around these prices for two months now. So it's not like the market hasn't had a chance to form its thoughts on how to react if Brainard has chosen.

Greg Anderson:

And I now think that the most likely FX response is to immediately sell out of large US dollar longs and then ask questions later. One of those questions would be the nomination hearing, by the way. If Biden were to nominate Brainard, the nomination would probably go through, but it wouldn't be a slam dunk like renominating Powell would be. And the market, I think, is going to assume that Brainard will be less hawkish than Powell. Therefore, rate hikes will have to come out of the curve. And I would think that the us dollar index would react to that with something like twopercent of downside in a week. At least under the Brainard scenario, if that were to play out.

Stephen Gallo:

That makes perfect sense, Greg. We'll be watching this space closely over the coming weeks, especially that choice for Fed chair. Let's wrap up episode 25 here until next time.

Greg Anderson:

Thanks for listening to global exchanges, listen to past episodes and find transcripts bmocm.com/globalexchanges.

Stephen Gallo:

We'd love to hear what you thought of today's episode. You can send us an email or reach out to us on Bloomberg. You can listen to this show and subscribe on Apple Podcasts, Spotify, or your favorite podcast provider.

Greg Anderson:

This show and resources are supported by our team here at BMO, including the FICC Macro Strategy Group and BMO's marketing team. This show is produced and edited by Puddle Creative.

Speaker 3:

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Speaker 3:

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Greg Anderson Global Head of FX Strategy
Stephen Gallo European Head of FX Strategy

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