EURUSD – ‘Great Meta-Expectations’
“Mass psychology really is the key to determine price action, at the end of the day.”
Anonymous Foreign Exchange Trader
Quoted in the “The Psychology of the Foreign Exchange Market”
Thomas Oberlechner, 2004
EURUSD is going lower. This is the accepted wisdom in the currency markets today, evidenced by the fact that a number of major investment banks (e.g. Goldman Sachs, Deutsche Bank, Citi) have now lowered their long term forecasts to below parity.
Meta-expectations are the expectations of market participants about the expectations of other market participants. It is such higher-order thinking that tends to drives currency markets, especially in the short term. At the moment, everyone thinks that everyone else thinks that EURUSD is going lower. So it goes lower. We are in the phase of the trend where it is advantageous to be a trend follower, and this will continue to push the euro lower from here.
The key question is, how long will this trend last? To quote another FX trader from Mr. Oberlechner’s fascinating book about the world of currency trading (in which he interviewed over 300 bank FX traders):
“In the foreign exchange market, when you get the trade recommendation from everyone saying ‘this is what you need to do’, you get all the predictions from all the strategists, ‘you know the euro is going top 1.30’ that is the time when you say ‘OK, well if everyone is thinking this, everyone is doing it, then it is not a great idea anymore’. And that is when the smart money starts getting out.”
Some smart money is at least starting to ask questions. According to Jared Dillian, former Lehman Brothers’ trader and writer of the market newsletter ‘the daily dirtnap’”:
“There really is no intrinsic reason to be the long the dollar unless you believe that the deficit is going to go to zero or the Fed is going to raise rates. They will not. Now, other currencies are a bigger mess, for sure, but this isn’t a long dollar trade so much as a short everything else trade.”
Considering the euro is now under-valued on a fundamental basis (as is the US dollar), it is likely that the ‘everything else’ will become less euro-centric, and more focused on currencies with other specific vulnerabilities (e.g. the UK’s current account deficit, or Canada’s housing bubble) in the longer-term. In the near term, a combination of meta-expectations and the ECB’s determination to look like they are doing something (anything), will push the euro lower.
GBPUSD – The ‘Lawson Doctrine’ Revisited?
In the late 1980’s, Britain’s Chancellor of the Exchequer, Nigel Lawson (who first ran for UK parliament in the constituency of Eton, the proud new home of Validus Risk Management) faced a problem. The UK’s current account deficit had reached a record level, at more than 5% of the country’s GDP, and fears were growing about a looming currency crisis.
Like many central bankers after him, Mr. Lawson chose to rationalize the problem, rather than deal with it. Current account deficits don’t matter, he pronounced confidently, at least if they are not accompanied by public sector deficits (Lawson and Prime Minister Thatcher had converted Britain’s large budget deficit into a healthy surplus by that stage). This idea came to be known eponymously as the ‘Lawson Doctrine’.
Lawson’s Doctrine proved to be a false one, however, as 1992 brought a sterling crisis, with the pound abruptly falling by almost 25% against the US dollar. Current accounts do matter, eventually.
Well, in 2015 the UK’s current account deficit is even bigger than it was in Mr. Lawson’s day. In fact, the UK’s current account deficit is now bigger than it has ever been in the post-war era, and the budget deficit in the UK is also huge (about 5.5% of GDP – imagine what it would be without ‘austerity’!). Presumably, even Nigel Lawson would be worried about sterling facing such ominous twin deficits…
Well, the currency markets seem remarkably sanguine about the prospects for the pound, with the trade-weighted sterling index rising by almost 4% last year. This does not appear sustainable. A study by the US Federal Reserve found that current account deficits in developed economies tend to reverse once they hit about 5% of GDP, through a combination of a slump in domestic demand, or through a fall in the currency. (Note: in the currency environment, a slump in domestic demand would likely weaken the currency as well, as it would ensure interest rates remained low). The study also found that such reversals are accompanied by large falls in the nominal exchange rate (40%) and a sharp slowdown in GDP. We remain bearish on GBPUSD for 2015 – although a near term correction higher looks likely.
GBPEUR – Currencies and Capital Flows
“Capital flows, both short-term and long-term, tend to drive fluctuations in currency values.”
Eswar S. Prasad, Cornell University
“The Dollar Trap”, 2014
The focus in 2014 was very much on the US dollar. As a result, the GBPEUR trade attracted very little attention – not surprising when you consider that the currency pair moved less than 7% over the course of the year (GBPUSD’s range, by comparison, was twice as big). However, with GBPEUR starting 2015 at five-year highs, and nearing the psychologically important 1.30 level, things might start to get a little more interesting.
The curious thing about GBPEUR is that, although the two currencies often tend to trade in tandem (rising and falling together against the dollar, for example), they really shouldn’t. If you believe Professor Prasad’s theory that capital flows drive currency markets, then the difference between sterling and the euro should be a stark one.
This is because capital flows are directly linked to a country’s current account. A country with a currency account deficit (e.g. the UK) needs to import capital from abroad make up for the lack of domestic savings. A country (or currency block) with a current account surplus, like the euro zone, will be an exporter of capital. Current account deficits should weaken a country’s currency over time; current account surpluses should strengthen it.
Not only are the UK and the euro zone on opposite sides of this particular divide, but they are at opposite extremes of it as well. The UK has the largest current account deficit (as a % of GDP) in the developed world (a whopping 6% of GDP), while the euro zone runs a large (and growing) current account surplus (almost 2.5% of GDP), and Europe is now the largest exporter of capital in the world, taking over this mantel from the Chinese. Not only that, but the UK’s current account deficit is at a record high, at the same time as Europe’s current account surplus is at a record high.
At the moment, the currency markets are ignoring this factor, deciding instead to focus on interest rate differentials and monetary policy (especially the possibility of euro zone QE). In recent years, large capital inflows from foreign investors (seeking either slightly higher yields than they could find in the US, or a safer destination for their capital than a crisis-plagued euro zone) have provided a backstop for the UK’s growing current account deficit.
However, we are reaching the limit of this flow, as investors will begin to get nervous as the current account deficit exceeds 5% of GDP. As such, the upside for GBPEUR is limited by the contrasting current account positions. The risks to sterling of a weakening appetite for UK assets due to this record deficit should not be ignored.
USDCAD – Not all about oil…
The recent fall in the Canadian dollar has coincided with a precipitous fall in the price of oil. However, the link between the Canadian dollar and oil is not as strong as it once was, and oil only makes up about 3% of Canada’s economy (compared to about a quarter of Norway’s, for example).
No, the main driver of the recent move higher in USDCAD was the general bull market in the USD. A fair question, therefore, is whether this USD Bull Run is running out of steam (see the section on EURUSD above), and, if so, what could this mean for USDCAD?
There are two reasons why CAD should continue to weaken against the USD:
1. The general trend of USD appreciation still has more to run (‘Meta-expectations’)
2. The Canadian economy faces its own problems, especially its extremely high levels of household debt, now estimated at 160% of household income and well above the level which triggered a crisis south of the border, and indeed worldwide (the US debt-to-income level peaked at 120% just before the 2008 financial crisis).
A recovery in the oil price could temporarily reverse the uptrend in USDCAD in the short term. However, the currency pair should see a 1.20 handle in 2015.
Author: Kevin Lester