Because the market sure could do with some humor on this blood red morning, we bring you FX strategist extraordinaire Thomas Stolper, who sadly does not give us the latest fade trade, but decides instead to come clean with pearls as: "On our EUR/$ forecast, last revised in January, we have been both right and wrong." Surely the "right" part is what he is worried about: after all if Goldman prop (whatever it is called these days) can't take the other side of the clients' trades, nobody gets paid. Yet Tommy still gets paid the big bucks: Why? For insights like these: "Cyclical forces and continued fiscal stress account for the lack of a EUR/$ rally...and we see little chance that they resolve themselves near term for EUR/$ higher." So cutting right to the good stuff: "Our structural, long term thought framework has not changed; we think global macro and flow fundamentals still argue for a weak USD and this theme will likely overwhelm other currency market developments on a one to two year horizon." We get it: the EURUSD can't go higher, but the USD is going lower. Mmmk.
From Goldman's Thomas Stolper
- On our EUR/$ forecast, last revised in January, we have been both right and wrong.
- EUR/$ hasn’t cratered, despite very negative sentiment. On this we have been right.
- But it also hasn’t rallied in line with our past forecasts. On this we have not been right so far.
- Cyclical forces and continued fiscal stress account for the lack of a EUR/$ rally, ...
- and we see little chance that they resolve themselves near term for EUR/$ higher.
- Longer-term we retain the view that broad USD weakness will reassert itself.
1. Market update
German industrial production for March announced yesterday surprised positively, attesting to continued solid underlying growth in the German industrial sector. After a brief squeeze higher, EUR/$ spent much of the day cycling around 1.30, as the uncertainty driven by the elections in Greece over the weekend continued to weigh on markets. European equities closed the day down 2-3%, while the SPX was down a more modest 0.8%. Sovereign bonds on the Euro periphery continued to take things in stride, with 10-year yields rising only modestly. This morning, risky assets continued to trade on the backfoot.
Elsewhere, Australia’s 2012-13 budget reinforced our bottom-of-consensus views on economic growth there, suggesting that the weight falls on the RBA to provide some stimulus to the economy as the Government moves to an unprecedented contractionary setting. We continue to expect the RBA to ease interest rates 25bps in June and 25bps in November 2012.
Given the latest round of nail biting over Greece, we today review where we have been right, and where we have been wrong, on our EUR/$ call. In particular, we quantify why EUR/$ has not rallied in line with our past forecasts, and assess the implications going forward.
2. Quantifying the drivers of EUR/$
While our long term EUR/$ views are driven by our structural bearish stance on the USD, ever since the European crisis began we have emphasized that near-medium term EUR/$ swings are primarily driven by three forces: (i) the weak balance of payments of the US vis-a-vis the more balanced picture for the Euro zone; (ii) interest differentials as a proxy for growth and monetary policy divergence between the Euro area and the US; and (iii) a fiscal risk premium, which measures sovereign distress on the Euro periphery.
Now, while most can agree on how to measure the interest differential – we have used 2- or 5-year swap rate differentials in the past – measuring the fiscal risk premium is tricky. What we have done in the past is to try a variety of things. We have used the relative performance of European versus US equity markets (see The Global FX Monthly, January 2012 ), and have also used the cross-currency basis as a measure of bank funding stress. Finally, we have used the GDP-weighted spread on 10-year sovereign bond on the Euro periphery over Germany (see Global Markets Daily: Quantifying the Drivers of EUR/$, Jan 26, 2012). None of these measures is perfect, of course. Our broad point here is simply that the Euro zone crisis has injected a risk premium into EUR/$ where previously there was essentially none, and that this risk premium has been – empirically speaking – roughly as important as the rate differential in explaining EUR/$ moves over the past year or two.
We can use such a framework to decompose the decline in EUR/$ from its peak in 2011 to now, focusing in particular on the roles of the interest differential and the fiscal risk premium in the recent EUR/$ move. For purposes of illustration, we use GDP-weighted Euro periphery 10-year bond spreads over bunds as our proxy for the fiscal risk premium. This exercise shows that – of the 18 big figure drop in EUR/$ between April of last year and now – 8 big figures reflect the interest differential, another 8 big figures reflect the fiscal risk premium, with the balance reflecting other factors we control for like global risk appetite and oil prices. In short, we think cyclical factors, like growth and monetary policy, and the fiscal risk premium have accounted in roughly equal parts for pretty much the entire fall in EUR/$.
In January we revised our EUR/$ forecast to 1.33, 1.38 and 1.45 on a 3-, 6- and 12-month horizon, respectively. The key element of our forecast was near term stability of EUR/$ (in the form of our 3-month forecast, while consensus was for EUR/$ weakness). That said, it has been a long-standing forecast of ours that EUR/$ would rally. For example, in September 2011 we had 3-, 6- and 12-month forecasts of 1.40, 1.45 and 1.50 for EUR/$. We now discuss in greater detail where we have been right and where we have been wrong on EUR/$.
3. Where we have been right and where we have been wrong
The fact that the EUR/$ has not fallen sharply year-to-date and actually rallied since its January low of around 1.26 is where we have been right, in particular since we made our forecast in January against the backdrop of pervasive EUR bearish sentiment. The fact that EUR/$ has held up well has underscored two of our core beliefs: (i) that USD is itself very weak, due to a weak balance of payments (see Global Markets Daily: The Largely Ignored Deterioration in US Flows, Dec 13, 2011 ); and (ii) short EUR positioning that remains large, so that a lot of bad news is already priced in. In these two respects, we have been right.
However, the EUR/$ strength we had been forecasting back in 2011 for 12-months out also has not materialized, and this is where we have not been right so far. Our thinking in the past had been that gradual policy progress and markets becoming comfortable that tail-risk scenarios like a full-scale Euro break-up are not going to happen would ultimately cause the fiscal risk premium to come down, providing EUR/$ with a boost.
What has happened instead is that fiscal consolidation has brought a hit to growth, which has weighed on EUR/$, while offsetting the more marginal benefits from any reductions in the fiscal risk premium. We had thought markets would gradually get used and look beyond the near term muddling through in Europe. Instead, currency markets remain skeptical in regards to fiscal and growth risks on the periphery.
4. Now what?
Our structural, long term thought framework has not changed; we think global macro and flow fundamentals still argue for a weak USD and this theme will likely overwhelm other currency market developments on a one to two year horizon.
At the same time, we have highlighted in our discussion above, the near term path for EUR/$ remains torn between the negative growth impact from fiscal consolidation and ultimately positive effects from a gradually shrinking risk premium. The balance between these two forces in the near term continues to look unclear, in line with our near term forecast for limited EUR/$ upside. Separately, though QE3 in June remains our baseline forecast, this is increasingly a close call, as Jan Hatzius once again flagged yesterday (see US Views: Still Dreary (Hatzius), May 8, 2012), further reducing the potential for EUR/$ top rally in the near term.