The Simple Reason Why Everyone's Wrong On The 'Short Euro' Trade (Including Draghi)

Tyler Durden's picture

Authored by UBS' Senior Global Economist Paul Donovan, originally posted at The Jakarta Post,

We live in stirring times. The president of the European Central Bank (ECB), Mario Draghi, crossed the monetary policy Rubicon and cut one of the Euro area’s key interest rates into negative territory. This is dramatic stuff, as even the most economically oblivious are likely to recognize that negative interest rates are a radical policy. At the same time the United States Federal Reserve is gracefully gliding out of its quantitative policy position — and by October that money printing process is likely to be effectively at an end.

The question from most investors is therefore “what next for US monetary policy?” The answer is likely to be an increase in US interest rates, and those increases may start earlier and take place faster than many investors currently assume. The Bank of England has been even more explicit in signaling a desire to tighten interest rates sooner than financial investors had expected.

Euro area monetary policy and Anglo-Saxon monetary policy are taking different directions — radically so. It has been a decade since the Fed last embarked on a tightening cycle, and Euro area rates have never gone negative before. The bias in discussions is whether the Fed and the ECB both do more than is currently expected; the difference is that “more” for the Fed means “more tightening”, while “more” for the ECB means “more policy accommodation”. With the expectations and the reality of the direction of interest rates diverging in this manner the instinct of most in financial markets is to assume that the Euro will weaken against the US dollar.

A weaker Euro has been forecast by financial markets for some time — and financial markets have been spectacularly wrong in their forecasts. The Euro weakened a little in the wake of the nudges and hints on policy from ECB President Draghi, but it still remains at a high level. How can this be explained? How is it that the Euro is not behaving the way everyone says it should?

A key part of the explanation for the Euro’s defiance of divergent monetary policy lies in a revolution that has taken place in the world economy. Put simply, globalization has collapsed dramatically since 2007, and that collapse in globalization has profound implications for financial markets.

The collapse in globalization is nothing to do with global trade. Global exports (as a share of the world economy) are at a higher level than they were in 2007 — here there has been a complete recovery. Instead the collapse has taken place in the realm of global capital flows. Global capital flows (again as a share of the world economy) are running at roughly a third of their pre-crisis peak, and around half the levels seen in the decade before the global financial crisis.

The collapse of global capital flows has been brought about by several factors coming together. Investors, in particular banks, are more regulated than before the crisis. With that regulation has come about a bias to investment in domestic markets — in some cases as an unintended consequence of regulation, in some cases as a direct policy objective. In addition the more political nature of several developed financial markets has acted as a deterrent to international investors, who are likely to have less understanding of politics in remote markets.

When capital flows were abundant, an economy with a current account deficit did not have too many problems finding the capital inflows necessary to finance the current account position. Only a tiny proportion of the huge amount of capital sloshing around the world had to be diverted to provide the funding. Now, with capital flows reduced to a thin trickle, a current account deficit country has to work a lot harder to attract the capital that they need. Crudely put, it is three times more difficult to finance a current-account deficit, now that capital flows are one third their pre-crisis levels.

This helps to explain the Euro. The Euro area is a current account surplus area. The United States is a current-account deficit area. The interest rate differential argues for a weaker Euro. The current account position argues for a stronger Euro. These two forces battle it out in the foreign exchange markets, and the result is less Euro weakness than many had expected.

This new model for foreign exchange has implications that reach far beyond the errors of Euro/dollar forecasting. Reduced capital flows means reduced capital inflows into Asian markets — something that has already slowed the pace of foreign exchange reserve accumulation. Reduced capital flow may mean a less efficient global allocation of capital resources. Global capital flows have been hidden from the headlines, but the collapse of globalization may turn out to be one of the most important economic changes of the past decade.

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ebworthen's picture

If you have to institute negative interest rates something is terribly wrong.

When savers are punished central banks have failed to support households and instead support banks.

The Euro has allowed the banks to punish households and use public treasuries for gambling in equity markets.

There is no moral, ethical, or even scientific (and Economics is not a science) justification for these policies that rob citizens.

Economics is the alchemy of the 21st century that allows banks to steal the "Gold" of the citizenry and return to them "Lead".

walküre's picture

You know what's next?

What is the only logical consequence if NIRP fails to do the trick? HAIRCUTS

Yes, right that's the only way FORWARD.

I've seen this show before. Just this time they actually pretend and proclaim that inflation is "too low". It's not low as everyone can see but they can't admit that or they would have to raise rates. They cannot raise rates after pumping trillions into the world economy because that money wants to earn interest. The chase for yield is just a sad symptom of this.

The money they pumped out has to be destroyed somehow or reigned back in.

During Weimar, the central bank openly diluted the money to try and settle debts and liabilities. It is the same today but the central banks try and mask the dilution with their endless propaganda of "low inflation". It's actually somewhat working because they all do it and the money still gets accepted at face value

They succeed in part because the rich are happy like pigs in shit and the poor are too dumb to understand that they're getting paid with toilet paper. Politicians do their part to sell the policies to the people and keep them stupid.

No growth, no increased revenues, no wage increases but pressures to increase prices for real food, not the synthetic crap. Eventually toilet paper won't buy anything real and the people can't live on synthetic crap forever. They want the real stuff and they're wondering why their paycheques aren't buying them anything.

Rainman's picture

Hmmm... that CA Surplus for Europe is calculated by the ECB. I go find my tin foil hat now.

LawsofPhysics's picture

What part of "all fiat goes to zero" don't people understand?  Forget "accounting" (it's all mark to fantasy now anyway).  There are people all over the world, skilled trademens, scientists, engineers, farmers, etc. who can create products of real value.  They are simply tired of the bullshit paper promises (created out of thin air) that central bankers and other financial fucks are offering them.  It is now a global economy, expect global consequences.  Simply put, and baring a global reconciliation, jailing of the "arsonist" (thanks timmay) and jubilee, what is coming is a global "Weimar".

hedge accordingly.

AdvancingTime's picture

I contend the primary reason that inflation has not raised its ugly head or become a major economic issue is because we are pouring such a large  percentage of wealth into intangible products or goods. If faith drops in these intangible "promises" and money suddenly flows into tangible goods seeking a safe haven inflation will soar. Like many of those who study the economy I worry about the massive debt being accumulated by governments and the rate that central banks have expanded the money supply.

The timetable on which economic events unfold is often quite uneven and this supports the possibility of an inflation scenario. A key issue being one of timing. If the price of gas jumps to $8 a gallon overnight do you buy gas and not make your car payment or stop driving the twenty miles to work? Answer, it could be months before your car is repossessed so you buy gas.

 It is important to remember that debts can go unpaid and promises be left unfilled. If this happens where does it  leave us? Chaos and major disruption would result from such a scenario. As we have seen from the economic crisis of 2008 and following many other unsettling developments legal actions can continue to drag on for years.  More in the article below.


kellycriterion's picture

Better send a memo to fellow contributor Chucky Smith, he's predicting destabilizing capital flight. Maybe to Japan.

Yen Cross's picture

   Europe has gone to negative rates because all of their quality collateral has been levered to the hilt, so they can't print without doing a repricing of assets. Europe is even more broken than the U.S. and any repricing of assets would just expose how fucked up Europe really is.

   The reason the Euro has stayed strong is because the Fed. bailed European banks out through swaps, reverse REPO's, and back door bond purchases, which kept a bid under bonds so that banks would buy them. The goverment and bank collusion in Europe is corrupt beyond belief.

   Europe a surplus eCONomy? In fuzzy common core math maybe. Europe is a deflating dieing economy, and Germany it's lifeblood is starting to show cracks.

kaiserhoff's picture

Good points, Yen

The labor costs and energy imports are enough to show Europe has major structural problems, and then there is up the wazoo regulation.  This won't end well.

walküre's picture

But Spain's 10 yr is lower than the US? Clearly the Spanish economy must be going gangbusters! US fairy tale growth in H2 is 3%, Spain is Don Quixote giants 6% !!!!

Disney is running the show everywhere now....

logicalman's picture

What I find amusing about the concept of 'bail outs' is that the supposed money used is worth bugger all.

So, one finacial scam falls apart and threatens another finacial scam's existence, so scam 2 'bails out' scam 1 with worthless bullshit.

I'm amazed how long this has managed to continue.


QQQBall's picture

European banks are NOT strong; just mispriced.

realWhiteNight123129's picture

Financial Flows are only one side of the coin: The other side of the coin is trade. When you print you make your internal price go higher, you lose on the terms of trade and your currency goes down as a result. 

Principles of Currency 1801, Henry Thorton, or read Fullarton 1848. People get fixated with capital flows... WRONG!

Britain had large inflation, weakening currency against the Deutsche Mark in the 1970s and gapping trade deficits... 

Printing money only helps the trade in the first few steps, as the money flows overseas in carry trade and does not enter the real economy. So your currency gets weaker because of the Carry trade but your internal prices have not risen yet, that is what happened initially to the US post 2009. 


Japan had much lower rates than the US for a long period of time in the 1990 and 2000 and did not ahve a depreciating currency in the 2000s. Why? Trade, not rates. 


In the classical gold standard, internal price falls was a resolution to a problem of trade. The internal price fall would attract both financial flows (cheap assets in local currency) and would also restore the terms of trade.

Those two forces still exist in floating currencies. By not letting its internal price fall, the US is guaranteeing a continued trade deficit, hemorraging of the real economy and whatever manufacturing might be left in the US, this only to the benefit of Banks which in an internal price deflation situation would suffer greatly, along with overxtended (junk) borrowers.

The real economy in the US is being eaten alive by the banking interests.





dragoneyes74's picture

As I say a lot, you usually don't have to worry about the first sharp pullback, but you better be on high alert for the retest of the high.  Equities are in need of a normal pullback, but in a bull market this mature, you always have to be on guard for the reversal off the high that is actually the top.  Mostly because that's what tops tend to look like.  Personally, what I'm looking for as a sign of the bigger pullback everyone knows has to happen at some point is the bounce off the weekly uptrend line that doesn't have the strength to make a new high.  Kinda like the Russell looks right now.  And if you look through a lot of the key stocks, many of them are approaching new highs but are currently making a lower high.  If that holds, I would think if enough of the key stocks run into the same technical resistence, it could be a problem for the market as a whole.  If I do any shorting it will be just short-term trades until I see the ES form a lower high.  But I'm done with the long side of the indices now.  You can have it. 

Silver and gold are also in need of some unwinding and they both pulled back from a resistence area today.  I was wondering if silver would make it to $22 before they unwound a bit.  We'll see.  I took half off today, so I'm good with either way.  If it goes to $22, I'll take the rest off there, and if it pulls back from here, I'm looking to buy the dip.  Ideally, gold will test $1300 or $1280 and silver will test around $20.  I don't see a reason why they shouldn't keep heading toward $26 silver.  

This is an interesting article about the Euro and it would support higher metals prices.  To me, a red flag for the metals is a Euro loss of 1.35 (the Draghi Day reversal).  It should be noted that it was the Commercials who stopped that down move with pretty significant buying.  So we will see how committed the Specs are to shorting the Euro and whether they can push through 1.35.  The EUR/USD has been the biggest waste of time for the last year.  

More importantly is how silver handles $22, if it gets there, that is.  I would like to see at least a pierce through the 22.18 swing high from Feb to feel much more confident that we're starting something big here.  Silver shouldn't visit the lower half of the $19s either.  The lowest a pullback should go is around $19.50 and it would be much better if $20 held.  Unless I see $19 silver I'm playing this for a move to $26.  


gdpetti's picture

Blame the Dutch for buying all those Tbills from Russia et al... hard to make your currency weaker when its in demand and it seems ever less central banks want our greenbacks these days, seeing how they have so many already. Maybe Draghi can play the JCB or Fed's game of easy money creation? See who can crash their currency first?

Debugas's picture

much more simple explanatin is - the world is abandoning dollar as reserve currency

AdvancingTime's picture

The games central bankers are playing in supporting their and other currencies has reached a dangerous level, we may be in the "red zone". Currencies are important chips in the commerce of government and the business of running a country. History has shown that in the past both leaders and governments have fallen with the demise of their coin.

If people lose faith in the system it could just come crashing down around our ears. At a time when billions of dollars can be traded in just the blink of an eye imagine how fast things could go to hell. More on this subject in the article below.


atoast2toast's picture

not bad, you are getting better at this.

COT data requires that you use a decent look back period, recommended 3 years. You forgot to include the events from last year in July which gives the current non-comm level some context.