In a new report that may come as music to the ears of Mario Draghi, who has been valiantly hoping to show the European economy recovering while keeping the EURUSD below the "red line" of 1.20, BofA FX strategist Athanasios Vamvakidis is out with a new note today urging currency traders to "stop fighting the central banks", in other words stop selling the USD and buying the EUR, and recommends shorting the EURUSD to 1.15 with a 1.21 stop loss.
His thesis is simple: markets have been fighting the major central banks, and BofA argues that they will be proven wrong, "leading to lower EUR/USD in the months ahead following the recent rally." Such a contrary posture by markets is unusual as markets usually follow the simple rule not to fight the G10 central banks, particularly the major ones. However, as Vamvakidis writes, "the market expects very little from the Fed in the rest of this year and next year, despite the unexpected two Fed hikes so far this year and the dot plot having four more hikes by end-2018. The market also seems to expects too much from the ECB-fast QE tapering-despite inflation being well below the target and room for slow QE tapering. The consensus is also that the two central banks will respond differently to low inflation this year, with the Fed staying on hold and the ECB giving up. We disagree and see EUR/USD weakening by the end of this year, following the strong rally so far."
He lays out the market's explicit "expectations" as follows:
Markets expect too little from the Fed: The consensus is that the Fed will focus more on low inflation and stay on hold. "We argue that the Fed will focus more on loose financial and monetary conditions, as well as risks to financial stability from asset price bubbles, and will continue normalizing policies gradually. We also argue that US inflation could start surprising to the upside."
The current dilemma for the Fed in our view is whether to focus on inflation or financial conditions. The two have diverged this year (Chart 1). Despite Fed tightening, financial conditions have been loosening (Chart 2). However, both price inflation and labor costs have dropped (Chart 3) and credit growth has slowed (Chart 4). Overall, US data has been mixed and data surprises have been negative, although less so recently (Chart 5)
The FX strategist then contends that the market seems to be focusing on the low inflation dynamics in the US. Indeed, the market is pricing only a 30% probability for a December hike this year and less than one hike next year. If inflation is so low and has actually fallen this year, what's the rush? As a result, risk assets have performed strongly, with equities at historic highs and volatility at historic lows.
Here BofA disagrees with this consensus for the following reasons:
- US inflation is surprisingly low given the position of the economy in the business cycle, but this may not last. The Phillips curve is not dead yet.
- The Fed is already behind the curve. Based on historical correlations, the Fed policy rate is too low to begin with compared with core inflation (Chart 11) and the output gap.
- The market is priced for perfection. Our Global Fund Manager Survey shows a record consensus for strong growth and low inflation. The risks are asymmetric if there is an inflation surprise.
- Even if inflation remains low, the Fed may focus more on financial conditions. Indeed, this is what the Fed has been doing so far this year, and for a good reason. We do not expect gradual Fed tightening to lead to even lower inflation, given that overall financial conditions are loosening and the Fed is already behind the curve. However, keeping policies too loose for too long could lead to asset price bubbles, which will eventually burst, leading to deflation risks. A forward looking Fed should take this into account, in our view. Why not take advantage of the good times to normalize policies, from a historically loose stance, to avoid risks from bubbles bursting down the road? Wasn't one of the key lessons from the Greenspan years that monetary policies should not focus only on inflation, but also on financial stability? Don't we know now that the Greenspan put was a policy mistake that led to moral hazard? Why repeat the same mistake twice, after having payed such a high price the first time?
- We note that the last time when inflation and financial conditions diverted was in 2013-14 (Chart 1). At that point, despite low inflation, the Fed announced and then started QE tapering, taking advantage of the market euphoria to normalize policies-and triggering the so called tapering tantrum. We expect their policy reaction function to be similar this time.
And at the same time as expecting too little from the Fed, "markets expect too much from the ECB"
ECB QE has an expiration date. For a number of reasons, the ECB does not seem willing or capable to increase the issue limit or relax the capital key in its QE purchases. QE will have to end next year. However, investors expect a relatively fast pace for QE tapering. Indeed, our Rates and FX Sentiment survey shows that most investors expect ECB QE to be over by mid-2018. Moreover, the market is pricing faster hikes by the ECB than by the Fed for the next three years (Chart 13).
Here the biggest bet by Bank of America is a simple one, and one which Yellen and most of her peers at the Fed recently warned against: the threat, and realization, that the Fed is stoking a bubble:
- We strongly disagree with the argument that central banks should ignore asset price bubbles. Eventual correction of bubbles could lead to a crisis and deflation, as we very painfully experienced in the last ten years. The Fed's credibility will suffer if a new bubble is formed, leading to another crisis down the road. Uncertainty on what is a bubble is not an excuse to do nothing.
- Micro-prudential measures can also help to address such concerns. However, the right and the left hands of a central bank should be coordinated, to avoid offsetting each other.
- We also disagree with the argument that the policy rate is too broad a measure to target asset price bubbles. After all, the policy rate is also too broad to micromanage labor market outcomes, but major central banks have been doing it anyway, particularly after the global crisis.
- At a minimum, a central bank needs to avoid forming a bubble in the first place. Unconventional monetary policies were a way to support risk assets after the global crisis and through this channel support the economy. There was strong justification back then. However, more recently markets have been over-relying on central bank policy support, to the extent that bad news (weak data) is good news (strong equities) because they keep monetary policy loose. This is an indication of market addiction to central bank support, which the central banks have been trying to slowly address and they will continue doing so, in our view.
- Asymmetric central bank policy response to asset price bubbles-doing nothing as they are formed and easing policies aggressively when the burst-will inevitably lead to moral hazard and more bubbles.
The key conclusion for BofA is that the market may be underappreciating the concerns of major central banks, and particularly the Fed, for being responsible for the next asset price bubble and a possible crisis after it bursts. Gradual policy normalization can take place despite low inflation under the current conditions.
In FX terms, assuming BofA is right, the FX implications is simple: weaker EURUSD.
The bottom line of the above discussion is a weaker EUR/USD. We believe that given what the market is pricing today for the Fed and the ECB and by how much the Euro has appreciated this year, the risks are asymmetric for a hawkish Fed surprise and a dovish ECB surprise this fall, leading to weaker EUR/USD by the end of the year. We understand that this is a contrarian call, given the EUR/USD performance this year and particularly in recent weeks.
And the recommendation:
We introduce a new trade recommendation to short EUR/USD spot based on our above analysis. Our target for EUR/USD is 1.15, which is also our year-end projection, with stop loss at 1.21, which is above the latest peak. Spot reference is 1.1891. Risks to this trade are the Fed not hiking again this year, the ECB announcing fast QE tapering and the Eurozone economy continuing to decouple from the US.
What are the trade downsides? First, here are the good, bad and ugly scenarios:
Considering alternative scenarios and the implications for the USD:
- In a good scenario, US and global data improves and market euphoria continues. In this case, we would expect the Fed to continue normalizing policies, supporting the USD. Monetary policy divergence and risk-on should support USD/JPY in particular, but EUR/USD could also weaken. The USD could also do well against GBP if Brexit negotiations are slow-as we expect, despite a more pragmatic UK government after the elections this year.
- In a bad scenario, something triggers a sharp sell-off in risk assets. In this case, we would expect the Fed to slow policy normalization, but the ECB would still have to announce QE tapering. EUR/USD would likely appreciate, although not by much, as markets are already pricing a very slow Fed. USD/JPY would suffer the most, but we would expect the USD to still do well against high beta G10 currencies, such as AUD, CAD and NZD, and against EM.
- In an ugly scenario, the sell-off in risk assets is much stronger, risking a global recession/crisis. We would expect in this scenario JPY and CHF, followed by USD and EUR to do well, against everything else. The EUR/USD implications would depend on the specific trigger and the details, and are hard to determine in advance.
Therefore, we believe the USD would do well in most scenarios, although one would have to be selective depending on the scenario. The USD could do particularly well against high beta currencies and EM FX.
All these scenarios also point to higher FX vol. This is easy to argue for the bad and ugly scenarios, starting from a point of low volatility. In the good case scenario, our expectation for higher vol is based on our thesis for Fed monetary policy normalization.
Finally, what is BofA is wrong about central banks?
- The biggest risk we see to our view is if Yellen is replaced by the end of this year-her term as a Fed Chair ends in February-and who would replace her. It is too early to have a view on who the next Fed Chair will be and whether and how the Fed's policy reaction function could change. We are assuming policy continuity, but we may be proven wrong.
- The second concern we have is that the Fed's message on how its policy reaction function takes financial conditions into account, particularly when inflation is low, has been mixed. The Fed's priorities were very clear to us under Bernanke, but Yellen has been flip-flopping, particularly this year. At times, she comes across as not having decided to respond to low inflation or to loosening financial conditions. Although we believe that the Fed will eventually do the right thing and try to prevent another bubble in assert prices, mixed messages this fall could keep markets guessing.
- We are more confident about the ECB. Their credibility is directly in question, as they are missing their inflation target and are forced to end QE next year because of technical constraints. Giving up is not an option. We expect them to use everything within their mandate to persuade markets that they will do whatever it takes to reach their inflation target. The inevitable QE tapering next year makes their work very challenging, but they could try using other tools. Otherwise, an even stronger Euro will bring them even further away from their target.
- Draghi will be faced with a very difficult communication challenge this fall. He has to announce a plan for QE tapering, despite the deteriorating inflation outlook, while persuading markets that the ECB remains committed to its inflation target. This will be tough. However, given market expectations, we see asymmetric risks from a dovish surprise.