Initial Thoughts on Draghi

While many investors are a bit stumped by the pace and magnitude of the dollar’s slump, Draghi seemed to imply that it was perfectly understandable given the recovery of the eurozone economy. The economy is the strongest it has been in more than a decade, but the US is no slouch. The US reports the first official estimate of Q4 GDP tomorrow January 26 and it will likely be the third consecutive quarter of above 3% growth.

How are growth impulses transmitted to the capital markets? One channel is the demand for capital and would be expected to increase which may increase lift real interest rates. Another channel is inflation. As the output gap closes, and rising input costs are passed on to customers, the general price level rises. In turn, the central bank is likely to adjust monetary conditions. This results in widening interest rate differentials.

The relationship between interest rates and exchange rates is not linear but cyclical. As a currency depreciates or is anticipated to decline, investors demand a greater interest rate premium to compensate for exchange rate risk. Over time, a sufficiently higher interest rate attracts flows back into it. Later, the currency begins to appreciate and the higher interest rate is no longer needed. The interest rate declines as the currency appreciates. Rinse and repeat.

By recognizing what he called endogenous factors (namely the macroeconomic improvement), Draghi accepted and validated the euro’s rise. In the context of recognizing that the currency needed to be monitored (when doesn’t it?), investors grasped Draghi’s remarks as milquetoast effort to push against the market and the euro’s rise. So it rose further.

Draghi could not push much harder. First, without new staff forecasts, his hands are tied. Also, the rise of oil has likely more than offset the rise of the euro in terms of impact on general prices (inflation). Secondly, Mnuchin’s comments clearly impacted the ECB’s discussion. While Draghi identified endogenous drivers for the euro, he cited also an exogenous driver. Without citing Mnuchin by name, Draghi clearly made reference to his remarks. Moreover, he noted that those comments violated the international agreement, and the IMF’s Lagarde seemed to echo a similar sentiment in Davos.

Europe is bristling by the seeming willingness of the US under President Trump to abandon the traditional US commitment to the multilateral world order that it was instrumental in developing. This applies to exchange rates, as well as the US obstructionist policies at the WTO, and its criticism of NATO. Draghi noted that “Several members of the Council expressed concern, and this concern was also in a sense, was broader than simply the exchange rate, it was about the overall status of international relations.

The market has run on Mnuchin and Draghi. What will stop the dollar’s sell-off is not official speak. It is not the likelihood of a Fed hike in the middle of March, which appears to be around 85% discounted. Rather the market will exhaust itself. Mnuchin did not begin the dollar’s sell-off, but he might have helped give it a last push before the overdue technical correction ensues. The euro has entered a very important technical area that extends from $1.25 to$1.28, which houses retracement targets and the monthly downtrend line from the euro’s record high in 2008 (~$1.6040).

US Dollar/Euro FX Cross Rate, Jan 2018

Source: markets.ft.com - Click to enlarge