The US dollar has been under sustained pressure for months, as the ‘Dollar Downfall’ narrative continued to gather momentum.  However, two competing narratives have recently emerged, clouding the outlook for currency markets.

It is difficult to state accurately or to quantify the reasons a few economic narratives go viral while most fail to do so.

Robert J. Shiller, ‘Narrative Economics’, 2019 

The euro-dollar rate does matter.

Philip Lane, ECB Chief Economist, September 1st 2020 

Very concerned about announcements from the British government on its intentions to breach Withdrawal Agreement. This would break international law and undermines trust.

Ursula von der Leyen, President, EU Commission, September 9th 2020 (via Twitter)

Last month, I examined the ‘Dollar Downfall’ narrative (link), discussing what I feel are flaws in its underlying logic, whilst acknowledging the potency of a viral market narrative.  As a brief refresher, the Dollar Downfall story asserts that we have entered a powerful bear market for the dollar,  due to a combination of growing US political risk, fiscal and monetary recklessness, and a general weakening of confidence in the dollar’s place at the centre of our financial system.   Subsequently, two competing narratives have emerged to challenge this perspective, and it is worth examining their legitimacy to get a sense of whether the ‘Dollar Downfall’ narrative is really under threat.

‘ECB Intervention’

As my colleague Marc Cogliatti noted last week (link), the first challenger, which I will call the ‘ECB Intervention’ narrative, arrived on September 1st, as the EURUSD rate hit 1.20.  As soon as this psychologically significant level was breached, Philip Lane, the ECB Chief Economist, known as Christine Lagarde’s ‘Monetary Brain’, came out with a brief statement to let the market know that the ECB was watching carefully.  EURUSD quickly tumbled back towards 1.18.

The ECB Intervention narrative asserts that the ECB will not tolerate a strong euro.  As an export-oriented economy, suffering from deflationary risks, Europe does not really want a strong currency, and Mr Lane has drawn a very clear line in the sand.  The ECB wants to keep EURUSD below 1.20. 

What is notable about the ECB Intervention narrative is that it is exogenous.  The ECB is deliberately trying to create this market perception to prevent excessive currency strength.   As any marketing executive will tell you, it is much harder to create a viral message than it is to ride an already-existing wave (which is why Kendall Jenner earns more than $500,000 per tweet).  For any manufactured narrative to work, it must have credibility – and this could be a problem for the ECB.

Firstly, the ECB does not have much in the way of monetary ammunition.  European interest rates are already negative, and the ECB’s balance sheet is far larger than the Fed’s (see chart).  Unless the market believes that the ECB is willing to directly intervene in the FX market (which it probably isn’t, at least not yet), then it is only a matter of time before 1.20 is breached again.  Secondly, although the ECB doesn’t want the euro to be too strong, there is also a view that the ECB is enjoying the euro’s time in the sun after a crisis-filled decade.  Challenging the dollar for reserve currency status beats trying to save the currency from collapse.

Chart 1: ECB Balance Sheet as a % of GDP (orange) vs Fed Balance Sheet as a % of GDP (blue)
Source: Bloomberg
‘Bad Brexit’

The ‘Bad Brexit’ narrative is not new, of course, but it did disappear for a while, due to the signing of the Withdrawal Agreement in January (and the (temporary?) avoidance of a no-deal Brexit), followed by the COVID pandemic which overwhelmed all other market drivers, including Brexit. 

However, when the Financial Times published a report (since confirmed) that the UK was about to introduce new legislation that could undermine the withdrawal agreement, Brexit was back as a handicap for sterling.  GBPUSD promptly gave up its recent gains and headed back below 1.30. 

It seems likely that Brexit will now continue to dominate the outlook for sterling until we have a resolution.  Either we get a deal (which will likely push GBPUSD back into the mid 1.30’s) or we don’t (in which case we will likely test 1.20 again). For what it’s worth, betting markets (narrowly) expect the latter (45% implied odds of no deal).

Chart II: Competing Narratives –  GBPUSD (Orange, LHS) and EURUSD (Blue, RHS)
Source: Bloomberg

In a 2019 (pre-COVID) interview, the Nobel prize winning economist Robert Shiller said: ‘Successful narratives are contagious.  They go viral and morph into epidemics just like an influenza epidemic that spreads around the world…they also fade, unless we have manipulators of narratives who keep trying to remind you…’   The Brexit narrative will likely persist, but, like the seasonal flu, its lifespan is limited.  The exogenous ECB Intervention narrative is highly dependent on the ECB to play the role of ‘manipulator’ and maintain credibility.  Expect this narrative to fade unless the ECB puts its money where its mouth is, and begins to directly intervene in the FX market.  Finally, the Dollar Downfall narrative, like the COVID virus itself, remains particularly contagious.  The most likely ‘vaccine’ will be a significant market event, a market or financial crisis, which truly tests the theory that the dollar’s safe haven days are behind it.  Unless and until such an event, the dollar will continue to face strong headwinds.

Author: Kevin Lester