Goldman's Thomas Stolper joins Erik Nielsen with an updated, and painfully bullish, Euro forecast: "our baseline is that these risks will not escalate much further." As Stolper is the guy who has successfully top.ticked.every.single.move in FX, it is time to call the undertaker (the profit margins on a coffin the size of Europe will be sufficiently high no matter the input cost of lumber). Not surprisingly then Stolper follows up: "we believe EUR/$ remains very much on track for the projected trajectory of 1.40 in 3mths as well as 1.50 and 1.55 in 6 and 12 months." Recall that Stolper came out with his upward revised EURUSD forecast just before the pair topped out in the low 1.40s (which was shortly after he scrapped his 1.15 target just after the eurozone stopped its implosion last time around after the Stress Test lie and QE2 rumors started). In other words, we just doubled down on our bet that John Taylor is once again spot on. What is unsaid here is that Goldman expects the world to start pricing in QE3 imminently, and punish the USD: "one question we face very often is about the viability of Eurozone growth with EUR/$ at 1.55. Our answer is that we really believe in broad USD weakness." At the end of the day, as we have claimed for over a year, the key dynamic is between the race of USD and EUR to devaluation: on one hand via outright currency printing and on the other via a continental disintegration. The one thing that many are forgetting, is that the faster a European crisis unwinds, the bigger the European banks' funding needs for dollars due to record FX asset-liability mismatch (and now, due to the dollar serving as a carry funding currency). In other words, the worse Europe gets, the doubly-faster that the Fed will need to print reserves to keep the dollar low. All that is a long-winded way to say that we anticipate Stolper will revise his EURUSD forecast lower within a month, once Goldman's ex-prop-now-"client facing" desks have accumulated enough USD positions.
The primary market focus currently is on Eurozone sovereign risks again. Our baseline is that these risks will not escalate much further. Specifically we believe that Spain will not need a bail-out as Francesco Garzarelli and Erik Nielsen have continued to highlight. Should this assumption turn out to be right, the EUR will likely strengthen again, otherwise we could see another sustained broad decline. In any case the current drop in EUR was not really a surprise. For example we highlighted since the summer in our FX research that the implementation phase of European fiscal tightening and further reforms will likely lead to renewed tensions and pressures on the Euro. Though to be fair, we initially thought this would materialise earlier.
At the latest forecast revisions in early October, we explicitly mentioned the risk of a temporary dip below 1.30 in EUR/$ on European sovereign issues and broader risk aversion. However, our baseline is that sovereign stress abates fairly quickly as otherwise our view of a relatively quick move back up may not materialise. And these fiscal worries are a powerful force, which even managed to temporarily overcome the risk correlations as we could see at the beginning of 2010, when stocks did well globally, the correlations in daily returns remained unchanged but where the sovereign concerns in Europe led to a strong temporary EUR down trend nevertheless.
A related risk is that fiscal tightening leads to much weaker growth performance in the Eurozone, but there again Germany acts as an anchor. With very little fiscal consolidation needed the overall fiscal tightening in the Eurozone will be far less than in the peripheral countries.
On the positive side, the latest round of PMIs suggests the core of the Eurozone may continue to show upside surprises, which over time would likely help alleviate sovereign stress and support the case for tighter ECB policy.
Overall, we believe EUR/$ remains very much on track for the projected trajectory of 1.40 in 3mths as well as 1.50 and 1.55 in 6 and 12 months. Of course, the biggest near term risk is further deepening of the Eurozone sovereign crisis and there is no doubt that further EUR/$ weakness would be the result. On the other hand, if things calm down again, opportunities for tactical long positions look increasingly good.
Finally, one question we face very often is about the viability of Eurozone growth with EUR/$ at 1.55. Our answer is that we really believe in broad USD weakness and hence the trade weighted appreciation of the EUR will be fairly limited if our forecasts are correct.
And some more:
Our EUR/$ Baseline Forecast
Sometimes we find it useful to look at an ideal USD downside scenario before comparing our forecasts with this benchmark. This approach helps looking beyond all the short term factors dominating the headlines and to cut out some market noise.
Starting with continued strong correlations to risky assets, it is pretty clear that the USD tends to weaken when risky assets perform well and vice versa. This in turn suggests that USD weakness requires a clearly positive outlook for cyclical assets. One of the reasons why this correlations still holds in our view is that a large number of foreign investors in US equities are currency hedged, whereas US investors in foreign stocks rather tend to be unhedged. As a result a global risky asset rally tends to translate into asymmetric flows from foreign investors who end up being under hedged and need to sell more USD against their home currency. A positive global decoupling scenario with persistent US imbalances is pretty close to such a weak USD scenario from a risk correlation point of view.
The hedging asymmetries also suggest that a scenario where the US is clearly in the process of adjusting the structural imbalances would ultimately be USD positive as equity investors may start reducing their hedging asymmetries. This in turn would lead to sizable USD buying.
Finally, looking at the policy mix, tighter fiscal and easier monetary policy in the US than in most other countries would also help reduce support for the USD.
Our current macro forecasts pretty much tick all the boxes. We expect a continued global recovery with still persistent imbalances in the US and easier monetary policy by the Fed than in most other places. On the basis of this global view USD weakness remains the most likely trend to dominate FX markets. As part of a trade weighted Dollar decline we would certainly expect the Euro to join in. And in fact, many of the macro factors in the US seem to be the other way round in the Eurozone, including tighter monetary policy and a positive risk correlation for the currency.