With central bankers preparing for their summer vacations, markets have been hanging onto their every word and nuanced syllable for guidance of what they may deliver in the Autumn. There was a mixed response to the ECB last week, the Bank of Japan was a non-event and the Fed is likely to deliver no major changes next week. We will have a look at the currency markets this week, specifically the Euro. First, however, we would like to highlight a new section in this week’s report.

Having been quite specific on trade ideas in last week’s commentary, a few readers have suggested it would be helpful if we tracked our trade ideas. This is not an advisory service, simply a macro market commentary, but we agree that for the sake of consistency, tracking past trade ideas will be useful in judging whether we are talking nonsense or not. We are not going to track all trades that we enter into in the portfolios we manage, but we will track trade ideas when we have been specific about them in our weekly commentaries as we generally have a higher conviction on these. So, you will find a table at the end of each week tracking how these trades are performing, which we hope may be of some use.

But back to the FX markets and the Euro. A couple of weeks ago we wrote about how we saw the Euro at an interesting juncture. Although we felt that the balance of risks indicated the Euro would struggle to overcome resistance in the 1.15 area against the Dollar, we were wrong. As can be seen in the first chart below, the Euro broke out (on the day of the ECB) and closed the week at 1.1663.

Chart 1 – EUR/USD exchange rate weekly chart

Frankly, we maintain the same “fundamental” reservations that we outlined two weeks ago. We still think that the Euro is too high when compared with interest rate differentials with the US. We simply do not see a major shift to a hawkish policy path by the ECB. And we think that shorter term traders have become too bullish on the Euro (or perhaps too bearish on the Dollar?) However, with price breaking above significant resistance, we have a bit of a dilemma. Do we turn bullish on the Euro, taking the view that the market price is the most important fundamental of all? Or do we exercise some patience in the weeks ahead and watch how price develops? We will go with the latter for the moment.

As noted above, the Euro broke higher on the day of the ECB meeting, and when we read and re-read Draghi’s prepared remarks and the transcript of the Q&A, we are struggling to see the obvious catalyst. Going into the meeting, we all knew that the current QE is set at EUR60 billion per month until December, and that the ECB will have to decide soon what they will do in 2018. So the fact that they think they will decide in the Autumn on a policy roadmap is simply not news. Furthermore, Draghi was keen to highlight that the broad message has been unchanged between the previous ECB meeting in Tallinn on the 8^th June (since which time 5 year German yield has risen by nearly 30 basis points and the Euro is some 3% or so stronger on a trade weighted basis), his speech at Sintra on 27^th June and the meeting this week. So, what is that message?

We think one of the key quotes from Draghi is this;

“First and foremost we have to look at the path of inflation, whether it converges in a sustainable and self-sustained manner to our objective”.

We are not in doubt that Draghi & Co are delighted that growth has been as good as it has been in recent quarters, that unemployment continues to fall and the deflationary risks of yesteryear have diminished. However, he also said;

“Therefore, a very substantial degree of monetary accommodation is still needed for underlying inflation pressures to gradually build up and support headline inflation developments in the medium term”.

And although the ECB sees the risks to growth as balanced, they also said;

“If the outlook becomes less favourable…we stand ready to increase our asset purchase programme in terms of size and/or duration”.

During the Q&A, we think he also made a couple of interesting comments indicating that he is not about to turn hawkish;

“There really isn’t any convincing sign of pickup for underlying inflation”.

“Basically, inflation is not where we want it to be, and where it should be”.

And having worked so hard to secure the recovery in the last five years, we doubt that Draghi will put this at risk by turning too hawkish too quickly;

“But let me make clear one thing: After a long time, we are finally experiencing a robust recovery, where we only have to wait for wages and prices to move to our objective. Now, the last thing that the Governing Council may want is actually an unwanted tightening of financial conditions that either slows this process or may even jeopardise it”.

 

 

And by financial conditions, we think that he will not be happy to see bond yields and the Euro rise too much too quickly. So, trying to piece this together, we do think that the ECB is nudging towards reducing QE into 2018. But that’s about it. Draghi confirmed again that they expect interest rates “to remain at their present levels for an extended period of time, and well past the horizon of our net asset purchases”. Will QE end in 2018? That depends entirely on inflation, and at the moment, the language from Frankfurt remains the same; there is some way to go before inflation sustainably meets their goal.

Currency rates are a relative value game, and next week we will hear from the Fed, and most likely, we will hear that the Fed has not changed policy. However, having raised rates last December, March and again last month, they have got into a quarterly routine and officially they are still looking to raise rates gradually and start reducing the balance sheet. Yes, Yellen has a tendency to be dovish, and the market believes that she has turned a bit dovish in recent weeks as inflation has slipped back.

This is true, but she also knows that the labour market is tight and she has highlighted how high asset prices are as well. Markets are pricing in a 40% probability of one more rate rise by year end. We still think that there is a decent probability that they announce the balance sheet reduction plan in September and raise rates in December. Even if we are wrong, we think that a dovish Fed is mostly priced in by markets. However, we stick to our belief that they keep (gradually) tightening until something breaks.

And this is the key for the EUR/USD exchange rate. We think that the market is over pricing the ECB normalisation and under pricing the Fed tightening, and that interest rate differentials will remain favourable for the Dollar in the months ahead. The chart below takes a big picture look at the EUR/USD exchange rate and the movement in the yield differential between US and German 5 year bond yields. Standing back, the exchange rate does not appear out of kilter with rates. Close up, the Euro may be a bit extended. And in terms of the future, we see bond yields moving broadly together, ie no major change in the differential.

Chart 2 – EUR/USD Exchange Rate and 5 year bond yield differential

 

On the issue of the market under pricing the Fed, the recent view that Yellen is returning to her dovish ways has led to a mauling of the US Dollar. If the Fed are to make no more changes to policy this year, then this recent mauling is perhaps the correct reaction. However, as we said, we don’t think the Fed is done now. We expect them to tighten via both balance sheet reduction and further rate rises. If this is correct, then the Dollar should be near a very good buying opportunity. We may not be quite there yet, with momentum clearly against the Dollar, but it is also clearly oversold, sentiment is now overtly bearish of the Dollar and traders have established large short positions, in some cases record short positions. This is the recipe for a meaningful low in the Dollar and we will write about this in more detail when we think we’ve got there.

So to sum up here on both the Euro and the Dollar. The FX market seems to be overly confident in the support that the Euro should receive from an ECB policy normalisation whilst also taking perhaps a too dovish view of potential Fed tightening later this year. The Euro has broken out on the charts against the Dollar, as has the Swiss Franc, the Aussie and Kiwi Dollars and the Canadian Dollar has been strong too. We are hesitant to jump on the Dollar bearish band wagon here, and wonder whether the FX market will continue its cruel tendency of sucking in as many players as possible into a trend just before it reverses. We may well be proved wrong in hesitating here, but we do think that patience could be a virtue and we can wait for a few weeks or so before deciding whether the Dollar is indeed in a new bear market or not.

Trade Summary

In this section, we will track the performance of trade ideas that we have highlighted in our weekly macro commentaries. We often write about investment themes which we may or may not implement in our portfolios, or where we have varying degrees of conviction. The trade ides that we highlight for inclusion will be our higher conviction ideas only, and so will not represent the performance of our portfolios. We hope this will be an easy and interesting way of tracking how we perform with our higher conviction ideas.

As noted in our commentary last week on soft commodities, we wanted to dip a toe in the market which we did on 14^th July. We also said that we hoped that we would be able to add to the trades if we started making money. With the trades moving into profit, we added to the trades during last week. The table below is a summary of what we have done and how each trade is performing. At the moment, all trades are still open and so the profit is marked to the close of trading on Friday. As and when we close trades, the profit/(loss) will be realised.

Trade Date	Trade	Entry Price	Trade Closed	Close Price	Realised P/L	Last Price	Open P/(L)
14/07/17	Long Cocoa	1892				1968	4.0%
14/07/17	Long Sugar	14.099				14.40	2.1%
14/07/17	Long Coffee	132.10				136.55	3.4%
19/07/17	Long Cocoa	1943.10				1968	1.3%
19/07/17	Long Sugar	14.42				14.40	-0.1%
20/07/17	Long Coffee	136.175				136.55	0.3%

 

Stewart Richardson
RMG Wealth Management