European Strength Continues
When the year began, political risks were concentrated in Europe, economic growth was expected to accelerate in the United States, and the U.S. dollar traded near 15-year highs.
Today, the European economy has surprised investors and economists alike, outpacing the U.S. economy through the first two quarters (Figure 1). Additionally, political risk premiums have mostly abated in Europe, while increasing in America. Interest rates have moved higher in Europe. And, the dollar has surrendered all its gains against the euro.
Figure 1: Simple Average of First and Second Quarter GDP Growth (Quarter over Quarter)
Source: Bloomberg, as of 7/31/17. GDP represents gross domestic product.
The change poses pertinent questions for today’s economic outlook:
- Will a stronger euro derail European growth prospects?
- Will the European Central Bank (ECB) or the Federal Reserve (Fed) rapidly change the path of monetary policy?
- Should the euro continue its strong appreciation against the dollar?
We find little evidence in support of each.
Strong Euro, No Worry
Sharp currency movements often weigh on economic growth, as exports become relatively more expensive and imports become relatively cheaper, but in this case, the currency may simply slow, rather than derail growth, for two reasons. First, a stronger euro may simply reflect a balanced improvement in outlook, rather than an impending shock. And second, while the euro has appreciated more than 12% against the dollar, in trade-weighted terms, it has only risen about 7%.
Recent soft data, also known as surveys of the current business environments, suggest that the European recovery remains well on track and should continue at above-trend growth levels for the remainder of this year and next. Also of note, growth was recorded across all nations covered by the survey. Seemingly, neither a rise in the euro nor hints of quantitative easing (QE) tapering took the steam out of the European economic recovery.
Draghi(ng) His Feet
Contrary to traditional economic theory, the link between money, growth, and inflation remains surprisingly weak. For example, Sweden’s economy grew at a rate of 7.1% between the first and second quarter of this year, per primary estimates of growth. And yet, inflation remained below 2% during that time.
Relatively muted inflation and market forces will help the European Central Bank (ECB) maintain a dovish path to normalize monetary policy. In late June, ECB President, Mario Draghi, sent both the euro and bond yields higher when he hinted at QE tapering. These concerns are at the forefront of central bank policy, as members want to avoid scaring both markets and growth.
Tighter Monetary Policy?
Despite recent hints of tighter monetary policy and two increases in the Federal Funds Rate this year (four since 2015), financial conditions remain more accommodative than when the year began (Figure 2) – a reminder that central bank tools are only so effective. Market forces, expectations, and uncertainty often have a larger impact on the availability of money.
Figure 2: U.S. Financial Conditions
Source: Bloomberg, as of 7/31/17. The 2-Year Treasury and 10-Year Treasury are represented by the generic 2-Year and 10-Year Treasury Yield. Credit spreads are the BofA Option Adjusted Spread to Treasury. The US dollar is represented by the USDX Index. U.S. Mortgages are represented by the Bankrate.com 30-Year Fixed Mortgage National Average. The percentage change represents the difference between the level at the start of the year (12/31/16) and the level today (7/31/17). A negative change suggests that financial conditions have become easier, while a positive change suggests tighter financial conditions. Past performance is not indicative of future results. An investment cannot be made directly in an index.
Given the more accommodative financial conditions both at home and abroad (Figure 3), we expect the Fed to maintain its policy course. Admittedly, inflation is low, and likely faces both temporary and structural headwinds, but we believe that inflation is around the corner. In the meantime, the Fed will be more willing to dismiss softness in inflation and focus on economic strengths like the labor market.
Figure 3: Global Financial Conditions
Source: Bloomberg, as of 7/31/17. The Bloomberg Financial Conditions Index tracks the overall level of financial stress in each country’s money, bond, and equity markets to help assess the availability and cost of credit. A positive value indicates accommodative financial conditions, while a negative value indicates tighter financial conditions relative to pre-crisis norms. U.S. represents the United States; Asia ex. Japan represents Asia excluding Japan; U.K. represents the United Kingdom; E.U. represents the European Union. Past performance is not indicative of future results. An investment cannot be made directly in an index.
Putting It All Together
Divergence remains a key theme for financial markets and currencies. Compared to the U.S., the Euro zone’s economy has more slack, and so the ECB is likely a few years behind the U.S. in both growth and policy. Accommodative policy is therefore likely to continue in Europe, while the Fed remains fixated on its gradual tightening campaign.
The sharp increase in the euro was certainly surprising and had many drivers – surprising growth, waning political risks, and talks of QE tapering, to name a few. While further appreciation is possible, additional appreciation might not occur in a straight line. Currency movements are not and will not be a one-way street. If you agree that the direction of the dollar and the euro will be difficult to predict, a 50% hedge may be worth considering when taking exposure to European equities.
Figure 4: Hypothetical Scenarios for the Euro
Source: Bloomberg, as of 7/31/17. UR/USD cross represents the Spot Exchange Rate, where the price of 1 EURO is in USD. The trend reversal and trend continuation are hypothetical scenarios for outcomes of the currency pairs. A trend continuation represents our base case for the currency pair. Past performance is not indicative of future results. An investment cannot be made directly in an index.
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The Bloomberg U.S. Financial Conditions Index (BFICUS) provides a daily statistical measure of the relative strength of the U.S. money markets, bond markets, and equity markets, and is considered an accurate gauge of the overall conditions in U.S. financial and credit markets.
BofA Option Adjusted Spread to Treasury – The BofA Merrill Lynch Option-Adjusted Spreads (OASs) are the calculated spreads between a computed OAS index of all bonds in a given rating category and a spot Treasury curve.
USDX Index – The U.S. Dollar Index (USDX, DXY) is an index (or measure) of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners’ currencies.
Bankrate.com 30-Year Fixed Mortgage National Average – Rate includes only 30-Year Fixed Mortgage products, with and without points. This index is the Overnight National Average.
Spot Exchange Rate – A foreign exchange spot transaction, also known as FX spot, is an agreement between two parties to buy one currency against selling another currency at an agreed price for settlement on the spot date. The exchange rate at which the transaction is done is called the spot exchange rate.
Tapering is the gradual winding down of central bank activities used to improve the conditions for economic growth. Tapering activities are primarily aimed at interest rates and at the management of investor expectations regarding what those rates will be in the future. These can include changes to conventional central bank activities, such as adjusting the discount rate or reserve requirements, or more unconventional ones, such as quantitative easing (QE).
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