USD Strength, European Political Outlook and EURUSD
Low yielding currencies should come under renewed pressure against the USD with the release of the Fed minutes of the 31 Jan/01 Feb and upcoming Fed speeches working in line with better global data releases as the catalyst. Overnight, it has been Fed’s Harker (voter) saying that he won’t take a March hike off the table, pushing US yields higher. Harker will speak again today joined by San Francisco Fed’s Williams (non-voter). However, the US 5-year inflation swap has eased by 22bps from its December highs despite commodity prices moving higher, the USD trading sideways and US data coming in on the strong side. Accordingly, US financial conditions have eased over the course of the past couple of months lending further support to the reflation trade. While US equity valuations have reached high levels, technical factors such like the advance/decline ratio and the continued relative advance of cyclical shares suggests that the risk outlook is likely staying supported for now.
Apart from political uncertainties there are almost no headwinds to the global economy. Global trade seems to be expanding rapidly as confirmed by South Korea’s 26%Y export gain reported for February. Last year, it was global economic headwinds combined with a sharp USD appreciation weakening the US growth and inflation outlook and convincing the Fed to reduce rate hike expectations. None of these headwinds have emerged this year. In contrast, strengthening US financial conditions have turned into a powerful tailwind which could unleash pent-up demand. Creating animal spirits pushing investment activity up will increase US capital demand, which suggests either a higher USD generating move capital imports or US bond yields breaking above the 10-year 2.51% technical resistance. Note it was the Fed’s Harker who talked about increasing signs of pent-up demand within the US economy.
When it comes it political risks all eyes are on Europe where government bond spreads are widening at a significant pace. Yesterday, an Ipsos poll showed Le Pen on 26%, compared with 19% for Macron and 18.5% for former PM Francois Fillon in the first round. That poll appeared to be driving markets but other recent polls have shown a wide range of possible outcomes, adding to market uncertainties. The focus may be on the political left in France, where a potential alliance between two parties could suggest a possible scenario of a left-wing candidate standing against the Front National’s Le Pen in the last round of the Presidential election, an outcome which would not be seen by markets as positive for future EMU reforms.
The market may react to the news that investigators have looked into the use of funds by some Front National candidates. However, if polls remain unaffected and Le Pens’ rating high, then investors may lighten semi and peripheral bond holdings further which should not bode well for the EUR. Ahead of the Netherlands general election due on the 15 March these pressures may even intensify. A good result for Geert Wilders from the Freedom Party could make it difficult for EMU-supportive parties to build a functioning coalition. It was only yesterday that EU’s Dijsselbloem, in respect of the ongoing Greek negotiations, said that creditors will focus on “moving away from austerity and focusing more on deep reforms, which was also a key criterion for the IMF.” Such deep reforms could be more difficult to implement in a potential scenario of increasing influence for European populist political movements.
Against this background we stay EUR negative. Next to political risks we underline the importance of Italian data when judging the EUR. Over the past few years there had been two periods when we saw the Italian economy improving. The first wave came along with the fall of BTP spreads, the second wave came when the EUR declined from 2014 onwards. It seems that Italy does need easier financial conditions to improve its domestic outlook. However, Italy’s financial conditions have recently tightened, not boding well for its economy.