Currencies In-Depth
In this Strategy Insight, we go over the RBA’s recent decision and the implications of its hawkish message for AUD trades.
We remain bullish the yen, despite the BoJ maintaining yield curve control. In this report, we outline a few reasons for this stance.
We remain bullish the yen, despite the BoJ maintaining yield curve control. In this report, we outline a few reasons for this stance.
Commodity currencies have been rather resilient, despite the broad rise in the dollar this year. In our view, we are about to experience a big rotation in commodity currency market performance at the crosses, from NZD, to CAD and finally to AUD.
In this report, we identify the Norwegian krone as a currency that could outperform especially at the crosses, irrespective of the broad dollar trend.
In this report, we assess that sterling likely bottomed below 1.04. We expect volatility in the currency to remain in place but are buyers below current levels. On balance, there is a tug of war between irresponsible fiscal policy and the pound as a global reserve currency. This will create a buy-in opportunity for investors who missed the latest dip.
Executive Summary Liquidity Will Shrink Further In Hong Kong The HKD is facing its most critical test in several decades. While the peg is likely to survive (Feature Chart), the economic costs for Hong Kong SAR will be far reaching. Critically, monetary policy in Hong Kong SAR is being tailored behind a hawkish Fed, while economic ties with China increasingly warrant easier policy settings. This tug of war will be resolved via a reset in domestic spending and asset prices. Equity shares have been the first shoe to drop. Real estate values and consumer spending will be next. A hypothetical delinking of the peg will see the HKD depreciate since it is expensive on a real effective exchange rate basis. Longer term, the rising use of the RMB in Hong Kong SAR will render the peg a relic. It will also fit with China’s aims to internationalize the RMB.. Bottom Line: The HKD peg is likely to survive in the near term, but the economic repercussions from maintaining the linked exchange-rate system will trigger a rethinking by the Hong Kong Monetary Authority (HKMA) and mainland authorities. Eventually, HKD could be replaced by the CNY. For now, HKD interest rates are slated to rise further, which will have ramifications for domestic spending and asset prices. Feature Chart 1HKD Has Been Tracking Interest Rates The Hong Kong dollar (HKD) has been trading on the weak side of its convertibility band since May. In theory, this suggests there is intense pressure for the peg to be delinked, which should lead to a much weaker exchange rate. In practice, interest rates in Hong Kong have failed to keep up with the surge in US rates, which has led to widening interest rate differentials between Hong Kong and the US. As a result, investors have embarked on a massive carry trade, funding USD purchases with HKDs (Chart 1). HKD’s weakness has raised questions about whether the exchange rate could face a crisis of confidence. This will be a severe blow to the HKMA whose sole role is currency stability, with the HKD being the underlying bedrock of Hong Kong’s financial system. In this report, we suggest that the HKD will survive this crisis, just as it has navigated previous shocks since 1983. The brunt of the adjustment will be domestic, first from Hong Kong equities, but spreading to real estate and consumer spending. Longer term, the HKD might become a relic as transactions in Hong Kong are increasingly conducted in RMB. Will The Peg Be Sustained? Historically, currency pegs more often than not fail. Specific to the HKD, the peg is facing its most critical test in decades but is likely to survive for a few reasons. First, every HKD that the region of Hong Kong has ever printed is backed by USD reserves, to the tune of 1.8 times. Quite simply, FX reserves are much higher than the Hong Kong monetary base (Chart 2). This suggests the HKMA’s “convertibility promise” remains credible. Second, Hong Kong also ranks favorably when looking at the ratio of broad money supply to FX reserves. Every 42.3 cents of broad money creation can be backed by foreign currency, a ratio much higher than China and on par with Singapore (Chart 3). With a monetary base fully backed by FX reserves and a broad money-to-FX reserve ratio largely in line with other linked exchange rate systems, our bias is that the peg will remain in place at least over a cyclical horizon (12-18 months). Chart 2In Theory, The HKMA Can Defend The Peg Chart 3The HKMA Ranks Favorably To The PBoC This credibility will come at a huge cost to the domestic economy, however. By having a fixed exchange rate system and an open capital account, Hong Kong has given up control over domestic monetary policy. Consequently, it must import monetary policy from the US. As interest rates rise in the US, demand for US dollar deposits from Hong Kong concerns goes up, putting downward pressure on the exchange rate. To maintain the convertibility ratio, the HKMA must drain the system of Hong Kong dollars to lift domestic interest rates. This is quite visible not only from the drop in foreign exchange reserves, but also the drawdown in the aggregate balance of domestic banks parked at the HKMA (Chart 4). From May 11 through August, the HKMA has absorbed a total of HKD 213 billion, shrinking the aggregate balance in the banking system by more than 60%. Chart 4Liquidity Will Shrink Further In Hong Kong Historically, the aggregate balance has had to drop much more to restore an equilibrium between interest rates in the US and Hong Kong SAR. The implication is that liquidity will continue to be drained from the system to ultimately defend the peg, and local interest rates will rise. There is one important caveat: Hong Kong SAR’s net international investment position stands at 580% of GDP, much higher than broad money supply. As such, the Hong Kong SAR does not have a solvency problem. What it faces is too much domestic liquidity, which is pushing HKD interest rates lower (Chart 5). Chart 5The HKD Is Facing A Liquidity, Rather Than A Solvency Crisis Ramifications Of The USD Peg When the HKD was tied to the US dollar in 1983, it made economic sense. Hong Kong SAR’s economy was more linked via trade to the US, compared to China (Chart 6). As such, stability vis-à-vis the US dollar was a vital appeal for traders, financiers, and all industries tied to the Hong Kong hub. Since then, there has been a tectonic shift in economic dependence. Exports to China now account for almost 60% of the total, while those to the US have fallen well below 8%. Quite simply, Hong Kong SAR still imports monetary policy from the US, while it is increasingly dependent on the Chinese economy. Nonetheless, there have been a few adjustments. The use of the RMB in Hong Kong SAR has been gradually gaining momentum. RMB deposits have risen to over HKD 800bn. As a share of narrow money supply (M1), it is almost 50% (Chart 7). There are also over 140 licensed banks in Hong Kong allowed to engage in RMB-based business. Chart 6Hong Kong And China Are Tied To The Hip Chart 7Hong Kong Is Transitioning Into A Defacto RMB System These links extend beyond just banking turnover. First introduced in 2014, the southbound trading links between China and Hong Kong SAR have become a major conduit for mainland investors to gain exposure to foreign firms. The China-Hong Kong stock connect has now handled over 2.6tn RMB in cumulative flows. This represented as high as 40% of the equity turnover in Hong Kong SAR (Chart 8). Capital account transactions have also been progressively relaxed, and the issuance of RMB bonds has been rising rapidly since 2008. Chart 8Lots Of Financial Links Between The HKD and RMB Hong Kong SAR’s strengthening ties with China comes with some good news. The increase in Chinese domestic liquidity is lowering the cost of capital for local enterprises. At the same time, it might also be fuelling very low domestic interest rates, forcing locals to chase higher rates elsewhere. This does not affect the peg if people sell the RMB to buy other currencies, including the dollar or maybe even the HKD. The bad news is that Hong Kong has now become a high-beta play on China as both economies are inexorably interlinked. Chart 9 shows that consumers in Hong Kong SAR tend to have much more volatile spending patterns compared to China, especially when economic growth is about to slow. One reason is that Hong Kong concerns are highly levered notably to the property market (Chart 10). For example, the debt service ratio in Hong Kong SAR sits at 32% of disposable income, much higher than China or other indebted economies (Chart 11). This makes the economy very vulnerable to rising interest rates. Chart 9Hong Kong Is Economically More Volatile Than China Chart 10Hong Kong Cannot Escape A Hard Landing (Part 1) Chart 11Hong Kong Cannot Escape A Hard Landing (Part 2) The bottom line is that as the HKMA withdraws domestic liquidity, this will reassert downward pressure on business activity and asset prices, particularly real estate. With private consumption a whopping 65% of GDP, household deleveraging will also prove to be a formidable headwind for domestic spending. Outside interest rates, Hong Kong SAR remains a trade hub. If global trade slows down meaningfully, this will lead to a deterioration in the current account. This triple whammy from slowing global trade, rising interest rates and consumer deleveraging could prove indigestible for Hong Kong assets. Policy Options Chart 12The Government Could Bail Out Hong Kong As highlighted above, the HKD peg will remain in place for the foreseeable future, but this will come at a huge cost. The advantage of the HKD peg is that the choice of the nominal anchor, the US dollar, renders it credible. As a financial hub, this is crucial for Hong Kong. Meanwhile, such an anchor also imposes fiscal discipline since government deficits cannot be monetized by money printing. In the case where the government tries to be profligate, the rise in inflation will lower real rates and lead to capital outflows. This will force the HKMA to sell US dollars and absorb local currency. Indeed, over the past several years, government debt in Hong Kong has been close to nil (Chart 12). The drawback of a fixed exchange-rate regime is that Hong Kong SAR has relinquished control over independent monetary policy. Such a union was justified when the economic cycles between the US and Hong Kong SAR were in sync, but now the region needs easier policy settings. The roadmap of the late 1990s could be what is in store for Hong Kong SAR. In short, the peg survived but the region went through a severe internal devaluation. During the Asian crisis, property prices fell by more than 60%. If that were to occur today, it would herald a prolonged period of high unemployment and stagnant wages to realign the region’s competitiveness with its trading partners. Hong Kong SAR stocks have already borne the brunt of an internal adjustment and are trading at very cheap multiples (Chart 13). The MSCI Hong Kong stock index is composed of mostly financials (47% of market cap) and property stocks (21% of market cap). As HKD rates are rising, loan growth in Hong Kong SAR is contracting and net interest margins have collapsed (Chart 14). This does not bode well for the near-term performance of financials. Chart 13Markets Have Already Discounted A Pessimistic Scenario For Hong Kong Shares Chart 14Banks In Hong Kong Are Facing A Tough ##br##Reckoning The good news is that similar to the late 1990s, banks are unlikely to go bust. Hong Kong SAR banks are well capitalized and delinquency rates are quite low, suggesting a banking crisis is unlikely to be a source of pain for the HKD peg (Chart 15). In fact, Hong Kong SAR banks rank favorably among their global peers in terms of capital adequacy (Chart 16). Chart 15Banks In Hong Kong Are Well Capitalized (Part 1) Chart 16Banks In Hong Kong Are Well Capitalized (Part 2) Specific to the currency, Hong Kong is also running recurring current account surpluses. This is boosting its FX reserves (Chart 17). That lends credibility to the peg in the near term. The bad news is that as the domestic economy slows down, and global trade comes close to a standstill, these surpluses could evaporate. One cost to Hong Kong is that the peg to the US dollar has made HKD incrementally expensive. Our model shows that the real effective exchange for HKD is about 2.5 standard deviations above fair value (Chart 18). Our view on the US dollar is that we could see depreciation over a 12-to-18-month horizon, but an overshoot in the near term is quite likely. A drop in the US dollar will help realign competitiveness in the HKD. Meantime, the market has also been pushing the currency towards the weaker side of its convertibility band. Chart 17Balance Of Payments Remain Favorable For The HKD Chart 18The HKD Is Expensive Longer term, as Hong Kong SAR continues to become more entwined with China, a peg to the CNY will make sense. This process will be the initial step in the region’s official embrace of the RMB system. That said, the process will be gradual since the US dollar remains very much a reserve currency, and the relevance of Hong Kong SAR as a financial center hinges upon easy access to the USD. What is more likely is that any re-pegging to the RMB will come many years down the road, when the yuan has become a fully convertible currency. The de-pegging of the HKD from the USD or adjusting the peg is as much a political discussion as an economic one. Political conditions for this change are not yet present given such a change will have major ramifications for the economy of Hong Kong SAR and will likely also reverberate through financial asset prices. One can imagine a scenario where HKD yields are forced to adjust to a new nominal anchor. Investors have been convinced through almost 30 years of history to treat the HKD as a proxy for the US dollar. That said, the economic pain associated with maintaining the HKD-USD peg will ensure authorities accelerate the use of RMBs in Hong Kong, with a goal of eventually adopting the yuan as the de facto currency. Adopting a currency board akin to Singapore is another option that makes sense, especially since this would give the HKMA scope to link to cheaper currencies, such as the yen and euro. That said, this is unlikely to be politically palatable, especially for Beijing. A link to the yuan that already does this job makes sense. Finally, there is always the option to fully float the peg, but this would probably increase currency volatility. This is unlikely in the near term. The Goldilocks scenario for policymakers is when the US dollar eventually depreciates against major currencies, easing financial conditions for Hong Kong SAR concerns. This will dovetail nicely with the goals of the monetary authorities, maintain credibility while easing financial concerns for a very levered economy. Investment Conclusions The HKD peg will remain in place, but the financial dislocations will lead to significant internal devaluation in Hong Kong SAR. As US interest rates rise, the HKD will be under considerable pressure. The HKMA will have no choice but to allow HKD interest rates to rise. This will tip the property market and thrust the economy into deflation and a recession. Chinese bonds are the best hedge against this risk. Avoid property and financial shares for the time being. Were the peg to break today, the HKD will depreciate according to our valuation models. This suggests markets are right to push the HKD-linked rate towards the weaker end of the convertibility band. Despite the economic and financial pain, the HKMA will not abandon the peg. That means carry trades will continue to make money. Using the HKD as a funding currency still makes sense in the near term. In long run, the economic pain associated with maintaining the HKD-USD peg will make authorities in Beijing accelerate the use of the RMB in Hong Kong’s special administrative region. The eventual goal will be for Hong Kong SAR to adopt the yuan as its currency. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com
Listen to a short summary of this report. Executive Summary A Beacon Of Hope For AUD Along with the Canadian dollar, the Aussie has been one of the best performing currencies during a broad-based dollar rally. Rising interest rates are part of the story, but there is more to Aussie strength than meets the eye. Aussie’s resilience is a conundrum worth exploring. First, it is a favorite short play for an imploding economic scenario in China, which suggests it should be a lot weaker. Second, the Aussie should be in the bottom quartile of FX returns in a risk-off currency scenario. Aussie strength can be attributed to strong commodity prices that are providing a terms-of trade-tailwind. Moreover, there is marginal evidence that demand for Australian-sourced commodities could be becoming a tad more inelastic. Chinese economic growth continues to disappoint, but upside surprises will be a welcome fillip for the AUD (Feature chart). On a terms-of-trade basis, the Australian dollar is very cheap. Falling commodity prices are a handicap, but the margin of safety on the valuation makes the AUD a safer bet. Go long AUD/USD if it touches 0.665 cents. AUD/NZD bets are also attractive. However, we will stay on the sidelines on AUD/JPY bets. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN LONG AUD/USD 0.665 2022-08-26 - Bottom Line: The Aussie dollar could go on a fire sale in the coming weeks. We would be buyers of AUD/USD at 0.665 cents. Feature The Australian dollar has been relatively resilient amidst broad-based dollar strength. Year-to-date, AUD is down 3.7% versus a 13.0% rally in the DXY (Chart 1). This is a remarkable development since historically, the AUD has been a very pro-cyclical currency, bearing the heavy lifting of any dollar rally. AUD/JPY, a key barometer for a risk-on/risk-off environment is up 13.4% year to date, despite a broad-based selloff in many risk assets. Chart 1The AUD Has Outperformed The Aussie’s resilience is a conundrum worth exploring. First, it is a favorite short play for an imploding economic scenario in China, which suggests it should be a lot weaker. Second, the Aussie should be in the bottom quartile of FX returns in a risk-off currency scenario. In this report, we explore base case scenarios for the Australian dollar, with recommendations for both short-term and longer-term trades, as well as plays at the crosses. Technical Indicators Technical indicators suggest the AUD could be ripe for a rebound. Our intermediate-term indicator bottomed at 5.55 and has usually been associated with non-negligible rallies in the AUD (Chart 2). This indicator is volatile and our expectation is that it could relapse in the near term. However, that will be good news for investors that have a constructive view on AUD prospects. Consistently, speculators are very short the Australian dollar. China’s zero COVID-19 policy, along with property market troubles have made the AUD a favorite short play (Chart 3). Given AUD’s resilience, this suggests that speculators are being overwhelmed by a tidal wave of fundamental currency inflows, through commodity purchases, bond market investors and Aussie equity sector bulls. Chart 2Technicals Point To A Coiled-Spring Rebound In The Coming Months Chart 3Investors Have Been Shorting ##br##AUD Australian Commodity Demand Chart 4A Beacon Of Hope For The AUD Weakness in China is well known and discounted by financial market participants. The latest selloff in the RMB is a case in point. Yet positive economic surprises in China have been improving relative to peers in the developed market (Chart 4). There are two simple reasons for this. First, the Chinese government is easing domestic financial conditions. Contrary to popular belief, lower rates and higher stimulus in China are positive for the AUD since it boosts Australian exports via higher domestic demand (Chart 5). With the Chinese bond market becoming more and more liberalized, it is also becoming a good proxy for monetary conditions in China. As such, lower bond yields in China have tended to lead imports. This is good news for Aussie exports in the coming months. Chart 5AStimulus In China Is Historically Positive For AUD Chart 5BStimulus In China Is Historically Positive For AUD Second, the Australian capital account could also be on the mend as foreigners are more willing to re-rate Aussie shares (Chart 6). The Chinese credit cycle has often led to a re-rating in Aussie shares. Our China and Emerging Market strategists argue that stimulus measures might not be sufficient to turn around Chinese domestic demand. In our view, that is well priced into the Aussie, which could potentially experience another selloff in the coming weeks. However, any upside surprises in Chinese growth will be a welcome fillip for the Australian dollar. Chart 6China And Australia Are Tied To The Hip A Few Moats Around The AUD Infrastructure spending is a huge chunk of Chinese fixed asset investment. So, while the housing downturn will impact commodity demand, infrastructure could provide a welcome offset. This could be a big moat that investors should pay attention to. Infrastructure is 24.5% of fixed asset investment in China and 18.0% of steel demand (Chart 7). Chart 7AStimulus In China Is Historically Positive For AUD Chart 7BStimulus In China Is Historically Positive For AUD On a relative basis, Australian terms-of-trade have outperformed other commodity-producing nations. This is some evidence that the external demand for Aussie commodities could be becoming a tad more inelastic. Among Australia’s exports, liquified natural gas has been increasing both in price and as a share of total volume (Chart 8). This is following a natural tailwind. China has an imperative to become greener, which has led to a rise in the share of renewables and natural gas electricity generation (Chart 9). Australia is in the top three biggest exporters of liquified natural gas in the world and exports world class clean coal that China depends on. The result has been a tremendous gain in terms of trade (Chart 10). Chart 8Some Aussie Exports Could Be Relatively Demand Inelastic Chart 9A Tailwind For Australia Chart 10Terms Of Trade Are Favorable In Australia Amidst this moat around the AUD is also a valuation cushion. As a result of strong export prices, the Australian dollar is undervalued on a terms of trade basis. While true that the AUD is vulnerable to a correction in commodity prices, the margin of safety on the valuation is sufficient for investors willing to ride out near term volatility (Chart 11). Remarkably, the 10-year government bond yield in Australia is 56.8 basis points above that in the US. This will have two profound opposing effects. First, from an interest rate perspective, it will cushion the drawdown in the Aussie, as interest-rate differentials matter for currency returns (Chart 12). On the other hand, it puts interest-rate sensitive parts of the economy, such as housing, at risk. Chart 11AUD Is Cheap On A Terms Of Trade Basis Chart 12AUD Is Cheap On A Fundamental Basis The Risks For The AUD The first risk for the AUD is a downturn in commodity prices. Chinese demand is genuinely slowing. This could lead to an undershoot in the AUD, as a terms-of-trade undershoot (Chart 13). That is why our recommended entry point is lower than today’s level at 0.665 cents. Chart 13A Commodity Correction Is A Risk For AUD Chart 14Housing Is A Big Risk For Australia The second consideration is housing prices. Real estate is experiencing a meaningful roll over in Australia. This has been led by Sydney and Melbourne, where prices were clearly overvalued, but the phenomenon is more broad based (Chart 14). Related Report Foreign Exchange StrategyTwo Decades After The Creation Of The Euro The impact for financial markets and the AUD is two-fold. First, if the RBA continues to tighten and as this flattens the Aussie yield curve further, it will not be a welcome development for bank net interest margins and profits (Chart 15). Second, the market has already priced in interest rates higher in Australia compared to the US (Chart 16). A slowdown in housing construction activity, that makes the Aussie consumer more cautious could temper the pace of RBA rate hikes and put pressure on the AUD. Chart 15Watch The Relative Performance Of Bank Shares Chart 16The RBA Might Be Relatively Dovish in 2023 A Few Trades Ideas Australia provides a lot of the commodities countries need and want in today’s paradigm. That is bullish. Yet exposure to China is a clear risk that investors need to factor into investment decisions. Our trading strategy is as follows: We would buy AUD/USD at 0.665 cents. In our view, it could undershoot this level but will be an attractive longer-term buy. The risks to the housing market are higher in New Zealand compared to Australia (Chart 17). Terms of trade also likely to favor the Aussie versus the kiwi (Chart 18). As such, bet on long AUD/NZD trades. Chart 17AUD Can Withstand Higher Rates Relative To NZD Chart 18Terms Of Trade Will Drive AUD Higher Relative To NZD AUD/JPY will benefit from a rally in risk assets but is stretched. Thus, from a sentiment perspective, we are only neutral (Chart 19). Economic surprises could also likely underwhelm in Australia relative to the unloved Japanese market (Chart 20). Chart 19AUD/JPY Is Stretched Chart 20AUD/JPY Is Stretched Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary
Listen to a short summary of this report. Executive Summary Euro Bulls Are Evaporating The euro is likely to undershoot in the near term, as the winter months approach and economic volatility in Europe rises. However, much of the euro’s troubles are well understood and discounted by financial markets. This suggests a floor closer to parity for the EUR/USD. Unlike many other developed economies, the fiscal drag in the eurozone is likely to be minimal for the rest of this year and early next year. The forces pressuring equilibrium rates lower in the periphery are slowly dissipating. That should lift the neutral rate of interest in the entire eurozone. China’s zero Covid-19 policy along with property market troubles has weighed heavily on the euro, but that could change. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Long EUR/GBP 0.846 2021-10-15 -0.13 Short EUR/JPY 141.20 2022-07-07 2.46 Bottom Line: The euro tends to be largely driven by pro-cyclical flows, which will be a positive when risk sentiment picks up. Meanwhile, making a structural case for the euro is easy when it comes to valuation. According to our in-house PPP models, an investor who buys the euro today can expect to make 6% a year over the next decade, should the euro mean revert to fair value and beyond. Our current stance is more measured because investors could see capitulation selling in the coming months. Feature Chart 1Two Decades After The Creation Of The Euro The creation of the euro was an ambitious project. It began with a simple idea – let’s create the biggest monetary union and everything else will follow, not least, economic might. Over the last two decades, the euro has survived, but its ambitions have been jolted by various crises. Today, the euro is sitting around where it was at the initiation of the project (Chart 1). That has been a tremendous loss in real purchasing power for many of its citizens. Given that we are back to square one, this report examines the prospects for the euro from the lens of its original ambitions, while navigating the economic and geopolitical landscape today. Surviving The Winter Chart 2A European Recession Is Well Priced In Winter will be tough for eurozone citizens. But how tough? In our view, less than what the euro is pricing in. According to the ZEW sentiment index, the eurozone manufacturing PMI should be around 45 today, but sits at 49.8. The euro, which has been tracking the ZEW index tick-for-tick has already priced in a deep recession, worse than the 2020 episode (Chart 2). Bloomberg GDP growth consensus forecasts for the eurozone are still penciling in 2.8% growth for 2022, down from a high of 4%. For 2023, forecasts have hit a low of 0.8%. It is certainly possible that euro area growth undershoots this level, which will cause a knee jerk sell off in the euro. However, much of the euro’s troubles are well understood and discounted by financial markets. Natural gas storage is already close to 80%, the EU’s target, to help the eurozone navigate the winter. Coal plants are firing on all cylinders, and Germany has decided to delay the closure of its nuclear power plants. It is true that electricity prices are soaring, but part of the story has been weather-related, notably a heat wave across Europe, falling water levels along the Rhine that has delayed coal shipments, and lower wind speeds that have affected renewable energy generation. France is also having problems with nuclear power generation, due to little availability of water for cooling reactors. Looking ahead, energy markets are already discounting a steep fall in prices from the winter energy cliff (Chart 3). If that turns out to be true, it will be a welcome fillip for eurozone growth. First, it will ease the need for the ECB to tighten policy aggressively, and second, it will boost real incomes, which will support spending. This is not being discussed in financial markets today. Chart 3AFutures Markets Suggest The Energy Crunch Will Ebb Chart 3CFutures Markets Suggest The Energy Crunch Will Ebb Chart 3BFutures Markets Suggest The Energy Crunch Will Ebb Fiscal Policy To The Rescue? Unlike many other developed economies, the fiscal drag in the eurozone is likely to be minimal for the rest of this year and early next year (Chart 4). As funds from the next generation EU plan are being disbursed into strategic sectors, including renewable energy, Europe’s productive capital base will also improve. This is likely to have a huge multiplier effect on European growth. Chart 4AThe Fiscal Drag In The Eurozone Could Be Minimal Chart 4BThe Fiscal Drag In The Eurozone Could Be Minimal Taking a bigger-picture view, what has become evident in recent years is stronger solidarity among eurozone countries, both economically and politically. Related Report Foreign Exchange StrategyMonth In Review: Inflation Is Still Accelerating Globally Economically, the standard dilemma for the eurozone was that interest rates were too low for the most productive nation, Germany, but too expensive for others, such as Spain and Italy. As such, the euro was often caught in a tug of war between a rising equilibrium rate of interest for Germany, but a very low neutral rate for the peripheral countries. The good news is that for the eurozone, a lot of this internal rupture has been partly resolved. Labor market reforms have seen unit labor costs in Greece, Ireland, Portugal and Spain collectively contract since 2008. This has effectively eliminated the competitiveness gap with Germany, accumulated over the last two decades (Chart 5). Italy remains saddled with a rigid and less productive workforce, but the overall adjustments have still come a long way to close a key fissure plaguing the common currency area. The result has been a collapse in peripheral borrowing spreads, relative to Germany (Chart 6). Ergo, interest payments as a share of GDP are now manageable. It is true that Italy remains a basket case but the ECB’s Transmission Protection Instrument (TPI) will ensure that peripheral spreads remain well contained and a liquidity crisis (in Italy) does not morph into a solvency one. Chart 5The Periphery Is Now Competitive Chart 6Peripheral Spreads Are Still Contained In Real Terms Beyond the adjustment in competitiveness, productivity among eurozone countries might also converge. Our European Investment Strategy colleagues suggest that the neutral rate is still wide between Germany and the periphery. That said, gross fixed capital formation in the periphery has been surging relative to core eurozone members (Chart 7). If this capital is deployed in the right sectors, it will have two profound impacts. First, the neutral rate of interest in the eurozone will be lifted from artificially low levels. The proverbial saying is that a chain is only as strong as its weakest link. This means that if the forces pressuring equilibrium rates lower in the periphery are slowly dissipating, that should lift the neutral rate of interest in the entire eurozone. Over a cyclical horizon, this should be unequivocally bullish for the euro. Second, and more importantly, economic solidarity among eurozone members will help ensure the survival of the euro, over the next decade and beyond. Chart 7The Periphery Could Become More Productive Trading The Euro The above analysis suggests long-term investors should be buying the euro today. However, the long run can be a very long time to be offside. Our trading strategy is as follows: Over the next 6 months, stay neutral to short the euro. The economic landscape for the eurozone remains fraught with risk. This is a typical recipe for a currency to undershoot. Eurozone banks are very sensitive to economic conditions in the eurozone, and ultimately the performance of the euro, and the signal from bank shares remains negative (Chart 8). Chart 8European Banks Are Not Part Of The Agenda Watch Eurozone Banks Investors have been cutting their forecasts for the euro but have not yet capitulated. Bets are that the euro will be at 1.10 by the end of next year, and 14% higher in two years. A bottom will be established when investors cut their forecasts below current spot prices (Chart 9). This corroborates with data from net speculative positions that have yet to hit rock bottom. Chart 9Euro Bulls Are Evaporating Real interest rates in the euro area are still plunging across the curve, relative to the US. The two-year real yield has hit a cyclical low. Five-year, 10-year and 30-year real yields are also falling. Historically, the euro tends to trend higher when interest rate differentials are moving in favor of the eurozone (Chart 10). Chart 10AReal Rates Are Dropping In The Euro Area Chart 10BReal Rates Are Dropping In The Euro Area Hedging costs have risen tremendously, as the forward market (like investors) is already pricing in an appreciation in the euro. The embedded two-year return for EUR investors is circa 4%, in line with the carry costs (Chart 11). In real terms, the returns are closer to 9% to compensate for much higher inflation expectations in the eurozone. Higher hedging costs will dissuade foreign investors from gobbling up European assets on a hedged basis. Chart 11A 5% Rally In The Euro Is Already Anticipated In short, the euro is likely to enter a capitulation phase. Our sense is that that it will push EUR/USD below parity, towards 0.98. Below that level, we believe the risk/reward profile will become much more attractive for both short- and longer-term investors. Signals From External Demand Chart 12The Euro Is Increasingly Dependant On Chinese Data The eurozone is a very open economy. Exports of goods and services represented 51% of euro area GDP in 2021. This means that what happens with external demand, especially in the US, the UK and China, matters for European growth (Chart 12). Of all its major export partners, China is the biggest question mark. China’s zero Covid-19 policy along with property market troubles has weighed heavily on the euro. Historically, the Chinese credit impulse has been a good coincident indicator for EUR/USD. Lately, that relationship has decoupled (Chart 13A). We favor the view that the credit transmission mechanism in China is merely delayed, rather than broken. For one, a rising Chinese credit impulse usually leads European exports, and this time should be no different. Chinese bond markets are also becoming more liberalized, and as such are a key signal for financial conditions in China. For over a decade, easing financial conditions have usually been a good signal that import demand is about to improve (Chart 13B). This is good news for European export demand. The bottom line is that investors are currently too pessimistic on Europe’s growth prospects at a time when a few green shoots are emerging for external demand. That may not save the euro in the near term but will be a welcome fillip for euro bulls when it does undershoot. Chart 13AThe Muse For The Euro Is Chinese Data Chart 13BThe Muse For The Euro Is Chinese Data Concluding Thoughts Chart 14The Goldilocks Case For The Euro The euro tends to be largely driven by pro-cyclical flows. Fortunately for investors, European equities remain unloved, given that they are trading at some of the cheapest cyclically adjusted price-to-earnings multiples in the developed world. Analysts are aggressively revising up their earnings estimates for eurozone equities, relative to the US. They might be wrong in the near term, but over a 9-to-12-month horizon, this has been a good leading indicator for the euro. Making a structural case for the euro is easy when it comes to valuation. According to our in-house PPP models, an investor who buys the euro today can expect to make 6% a year over the next decade, should the euro mean revert to fair value and beyond (Chart 14). Meanwhile, beyond the winter months, inflation could come crashing back to earth in the eurozone, which will provide underlying support for the fair value of the currency. Our near-term stance is more measured because investors are only neutral the euro, and risk reversals are not yet at a nadir. This is particularly relevant given that Europe still has a war in its backyard, with the potential of generating more market volatility ahead. Given this confluence of factors, we have chosen to play euro via two channels: Long EUR/GBP: As we argued last week, the UK has a bigger stagflation problem compared to the eurozone. This trade is also a bet on improving economic fundamentals between the eurozone and the UK, as well as a bet on policy convergence between the two economies. Short EUR/JPY: The yen is even cheaper than the euro. In a risk-off environment, EUR/JPY will sell off. In a risk-on environment, the yen can still benefit since it is oversold. Meanwhile, investors remain bullish EUR/JPY. Long EUR/USD: We will go long the euro if it breaks below 0.98. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary