After briefly becoming the strongest currency in the world for 2013, yesterday's stunning inflation report out of the Eurozone has not only left the massively overblown European recovery story in tatters (but... but... those soaring PMIs, oh wait, John Paulson is investing in Greece - the "recovery" is indeed over), has sent the sellside penguins scrambling with the new conviction that the ECB now has no choice but to lower rates once again, either in November or in December. So with everyone confused, we were hoping that that perpetual contrarian bellwether Tom Stolper, who just came out with a report, may have some insight. And sure enough, while the long-term EUR bull admits that "the ECB could move the EUR/USD cross by about 5 big figures by cutting the refi rate by 25bp" and that "it is quite possible that we will see EUR/$ drop further towards 1.33", he concludes that "an ECB rate cut could turn out to be a buying opportunity to go long the EUR." And now we know: because what Stolper tells his few remaining muppets to buy, Goldman is selling: if and when the ECB cuts rates, do what Goldman does, not what is says: sell everything.
From Goldman's Tom Stolper
Should the ECB respond to a strong Euro?
On a trade-weighted basis, the EUR is the strongest currency globally – Earlier this week the EUR was briefly the strongest currency globally in 2013. On our GS Trade-Weighted Indices, it peaked at +5.9% year-to-date, outperforming by a whisker the CNY at 5.7%, with the Dollar remaining far behind at +2.0%. Apart from the fact that this has surprised consensus expectations for 2013, it is also becoming a headache for the ECB. At every post-meeting press conference President Draghi faces a number of questions about the exchange rate. In addition, our GSDEER fair value framework implies that the EUR is now overvalued by about 14% against the Dollar and by about 5% on a trade-weighted basis.
The Euro area’s current account position stands in contrast to the EUR valuation signals – Most FX valuation models, including Purchasing Power Parity, are ultimately trade arbitrage models. If goods are substantially cheaper in one country than another, the chances are that people will buy more of the cheaper goods and the resulting demand for the currency in the producer country will help correct the undervaluation. A strong currency over-valuation signal therefore often coincides with a trade deficit and a subsequent correction, as we have seen in EM deficit countries recently. In the Euro area that is not the case. Despite overvaluation, the Euro area currently is not running a current account deficit; in fact, it has the largest surplus ever at about 2.5% of GDP (Germany's is 7% of German GDP). Even vis-à-vis the US, where the EUR is overvalued by 14%, the bilateral Euro area trade surplus currently stands at historical record highs. The opposing current account and valuation signals considerably complicate the case for a weaker EUR.
Euro weakness would theoretically deepen imbalances – Of course, one of the reasons why the Euro area current account surplus has been growing has been slowing domestic demand depressing imports. Using a weaker Euro to substitute domestic demand would support growth but likely increase the imbalances. At least theoretically, the currency depreciation would raise the trade surplus even further. From a G-20 point of view this would be a very controversial policy (even if officially aimed at inflation alone). Already the US is criticising the German government for not stimulating domestic demand more, and the idea of pushing the EUR lower to help growth is met with scepticism in Asia.
An uncertain impact on growth from FX depreciation – Given the frequent calls to depreciate the Euro to boost Euro area growth and raise inflation, we take a quick look at the likely empirical impact. On the growth side we can extract the likely effect of EUR depreciation from the work of our Euro area colleagues in 2009. They estimated trade elasticities for the Euro area and calculated different scenarios for real TWI moves. Relative to a baseline forecast, a permanent real effective depreciation of 10% would raise GDP growth in the first year by 0.4% to 0.5% and in the second year by 0.2%. This is broadly in line with other estimates of trade elasticities but it is also important that the range of estimates varies considerably across a large number of empirical studies. Some authors fail to find evidence of the critical assumption that depreciation leads to an improvement in net trade (technically known as the Marshall Lerner condition). Some recent studies (see, for example, http://www.feb.ugent.be/FinEco/gert_files/research/JMCB_FP.pdf [12]) emphasise that exchange rates, net exports and growth are all endogenous and that the nature of shocks will ultimately determine if depreciation coincides with accelerating growth. All said, it is likely that a weaker exchange rate will help growth but the impact is probably weaker and more uncertain than most observers believe. Similarly, the impact on core inflation of exchange rate moves is also difficult to quantify.
How much extra growth for an ECB rate cut? – We estimate that the ECB could move the EUR/USD cross by about 5 big figures by cutting the refi rate by 25bp. We discussed this in more detail in a Daily this week, where we also cautioned that this estimate is unlikely to be more than a guide to the order of magnitude of the response. Historically, a 5-big-figure drop in the EUR corresponds to about a 3% decline in the trade-weighted exchange rate. To calculate the impact on growth, we can use the estimates of our European colleagues. Assuming that this drop is permanent, it would boost Euro area growth by a bit more than 0.1 percentage points in the first year and by a touch more than 0.05 percentage points in the second. It could well be less if the EUR rebounds after the initial decline.
A substantial EUR depreciation to boost growth meaningfully – In order to see a more meaningful impact on growth, for example via a 10% decline in the real TWI, the EUR would have to drop to levels last observed in mid-2012, before the ECB announced the OMT. And again, the EUR would have to stay at those lower levels to get the full growth benefit. To get such a large EUR depreciation the ECB would have to pull many more stops than just a 25bp cut in the refi rate. In addition, the ECB would have to overcome what looks like an underlying appreciation trend. We find evidence of such a trend in our econometric work and it would be consistent with the strong balance of payment position. Our estimates currently suggest that the Euro drifts higher – all else equal – by about 1 big figure per month currently.
Tough FX policy choices in the Euro area – To summarise the challenges for FX policymakers in the Euro area, bringing the Euro down may not help as much as hoped for: it may increase political frictions, deepen macro imbalances and it is difficult to achieve in a meaningful way in any case. As the US Treasury suggests in its semi-annual report, boosting demand in Germany would be a far more effective policy to support growth in the Euro area. Given all these issues, we would be surprised if the ECB made the exchange rate the primary motivation for a policy move.
An ECB cut is possible... – To be sure, there may be other, mainly domestic, reasons to cut policy rates in the Euro area, including the surprisingly low inflation print this week. Demand remains weak in the Euro area and monetary conditions have tightened in recent months, partly linked to the global bond sell-off. In particular, if the disinflation trend persists in the next reading our Euro area economists think a December cut is becoming a close call. And even a cut at the policy meeting next week cannot be ruled out. In turn, such a cut – or the increased likelihood of such a cut – would still have a EUR-negative implication, as discussed above, even though it is already partly being priced by rate and FX markets. On that basis, it is quite possible that we will see EUR/$ drop further towards 1.33.
...but could turn out to be a buying opportunity – However, we are of the view that a rate cut would not be the beginning of a larger attempt to manage the currency weaker. In that respect, an ECB rate cut could turn out to be a buying opportunity to go long the EUR. Our view would change if markets started to price a much more hawkish Fed and the prospect of a genuinely widening interest rate differential with the US. But even then, one would have to factor in the EUR-supportive balance of payment flows.