It is perhaps ironic that two days after Goldman Sachs, on Friday evening, acknowledged that hopes for a June rate hike by the Fed have now been dashed...
Primarily because of our below-consensus inflation call, we continue to expect a later-than-consensus first hike. As Exhibit 8 shows, most forecasters continue to expect a first hike in June, in line with the clustering of Fed officials around “mid-2015” as a likely liftoff date. Our baseline remains September, and we view the risks as increasingly skewed to the later side. If core inflation falls as low as 1%, we think that the liftoff would probably move into 2016.
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... a forecast that only the most confused macro-economists, and Virtu's FX algos of course, thought was credible and one which is about to be thoroughly voided now that Winter Storm Juno is about to unleash the first blizzard of 2015 over New York City and the northeast perhaps "forcing" the Fed to follow the ECB, Denmark and the SNB into all-out NIRP territory, that Goldman has decided to release a report, in which it it says that "recent moves and ECB easing do not signal the beginning of the end" for the USD surge in recent months, adding that "These moves will run a lot more. They are 'the end of the beginning'."
It is by now clear to most that one of, if not the main drivers of the unprecedented USD strength in the face of a global deflation and economic deterioration in the past 6 months, has been due to the Fed's optimism that the US economy and US corporations are strong enough to sustain a rate hike and a much stronger dollar.
Well, if the Fed is about to admit that is not the case, what happens to the strong USD case? It falls apart of course, especially since as we also noted last week, the US commerce secretary said the US is now actively looking [11]at the "strong dollar." It also means that being long the USD - the most consensus trade of 2015 alongside being short USTs (again) - is about to fall apart. However, for that to happen, the big banks need to be able to offload their long-USD exposure on someone, preferably muppets.
Which explains the extensive note Goldman has released this morning, cited above, and titled dramatically enough, "The End Of The Beginning."
This is what Goldman has to say in order to assure that clients flood Goldman's prop pardon flow traders with "Buy USD" orders: orders which Goldman, being on the other side, will be delighted to fill.
1. Foreign exchange rates are trending in a big way, after many range-bound years. This change is difficult to embrace. After all, as much as markets like to think of themselves as forward-looking, the truth is that we are all backward-looking to some degree and update our perception of the world only gradually (economists call this adaptive expectations). In the current setting, where we have transitioned from a range-bound to a trending market, this means pushing back against the instinct to wait for the pull-back, the positioning wash-out, the correction. This is not to say that corrections won’t happen. They surely will. But in a trending market those corrections may happen at levels that are even less appealing than where the market currently is. Of course, reluctance to embrace the trend also reflects something else: skepticism that the trend has further to run. On this we would make two points. First, while the Dollar has strengthened about 17 percent since the middle of last year, this is from very depressed levels and it is still below the historical average (Exhibit 1). Second, unprecedented easing from the Fed has kept the USD below where it otherwise would have been. In an FX Views almost a year ago, we estimated the “unobstructed” level of the Dollar 13 percent stronger, obviously not counting the dramatic ECB and BoJ easings that have come since then. There is still plenty of Dollar upside on this metric, as the 2-year differential continues to move higher (Exhibit 2). In short, recent moves and ECB easing do not signal “the beginning of the end.” These moves will run a lot more. They are “the end of the beginning.”
2. We – like everyone else – have struggled to adapt our mindset fast enough. Although we embraced Euro downside earlier than most (Exhibit 3), the speed of the move has surprised even us. That said, our forecasts foresee a sustained and prolonged weakening of the single currency to 0.90 in 2017. There are many pushbacks to this view, including that downside is heavily positioned and that the current account surplus of the Euro zone puts a floor under EUR/$. We have consistently argued that positioning is light and think recent price action validates this. With respect to the current account, we think there is a conceptual misunderstanding. Exchange rates, like all market prices, incorporate expectations for things, including the current account. The mere existence of a surplus therefore does not push EUR/$ higher, while a surprise to the upside – a larger than expected surplus – does. Our expectation is that QE will ease financial conditions on the periphery, allowing consumption to rebound from depressed levels. That will tend to widen Euro periphery current account deficits back out, capping any improvement that may come from Euro weakening. In short, we believe the current account is a sideshow. In contrast, we think these things are important:
- The Euro has spent many years significantly above fair value, including post-2012 when the OMT pushed the EUR/$ up from 1.20 to near 1.40 (Exhibit 4), a large deflationary shock that was an unintended side-effect of “whatever it takes.” Cyclical underperformance vis-à-vis the US, the regime break at the ECB as evidenced by QE and still significantly overvalued real exchange rates on the periphery all now point to a significant undershooting of fair value, in line with our longer term forecasts.
- The market is focused on whether QE will attract foreign flows into the Euro zone, presumably because OMT caused such a large rebound. We make two observations. Gross foreign portfolio inflows into the Euro zone look to have remained very strong in the run-up to QE (Exhibit 5). Even if QE attracts more inflows, given how elevated foreign inflows already are, we don’t think the upside for the Euro from this source is large. In contrast, gross portfolio outflows by Euro zone residents have been steadily picking up (Exhibit 6), to such an extent that the 12-month average is now negative (meaning more portfolio outflows than inflows). The regime break at the ECB will cause outflows to gather pace in coming months, sustaining the decline in EUR/$.
3. The nice thing about EUR/$ downside is that it has been, and continues to be, an idiosyncratic story, not just a Dollar bull story. This week’s rate cut from the Bank of Canada (BoC) moves the Canadian Dollar from a beta play on the Dollar back into the idiosyncratic camp. That is because the cut is something of a regime break (Exhibit 7), whereby the BoC in the past has closely shadowed the Fed, but broke from tradition this week. The reason is the drop in oil prices is on balance a negative for Canada, in contrast to the US, as Deputy Governor Lane laid out in a speech in the run-up to the meeting. That negative is not yet fully reflected in the BoC’s latest forecasts, which assume Brent at $60, which is why Governor Poloz left another rate cut on the table in last week’s press conference (Exhibit 8). We think the regime break and downside to the BoC forecasts sets the stage for more Canadian Dollar weakness, and revise our forecasts for $/CAD to 1.28, 1.30 and 1.32 on a 3-, 6- and 12-month horizon (from 1.19, 1.20 and 1.22, respectively), as well as 1.36 end-2016 and 1.40 end-2017 (from 1.24 and 1.26, respectively).
4. We also revise our EUR/CHF forecast to 0.98, 0.96 and 0.95 on a 3-, 6- and 12-month horizon following the SNB surprise two weeks ago (from 1.25, 1.28 and 1.28, respectively). The SNB sent two messages with its decision to de-peg: (i) it has revised its expectations for EUR/$ materially lower, making a peg to the single currency (and the potential reserve accumulation involved) unattractive; and (ii) its decision to cut its target range for 3-month Libor reflects a distaste for intervention in the near term, in essence shifting monetary policy back to interest rates from balance sheet expansion. We believe therefore that the near term path of EUR/CHF is lower, given that the safe haven status of the Swiss Franc has emerged stronger from recent developments. In the longer term, we think EUR/CHF will revert towards fair value (around 1.40 on our GSDEER), so that we put our end-2016 forecast at 1.00 and end-2017 at 1.10 (from 1.29 and 1.30, respectively).
And with that, Goldman will be delighted to sell you all the USD you have to buy.
