When the euro was going down in a straight line, it was easy for currency bears to call for the exchange rate with the dollar as low as 0.80. Now when, after a year of beating, EURUSD at last had a good month, the bearish convictions are being put to the test.
Some believe the economic data is beginning to support the reversal. Indeed, the US releases have been mixed at best lately. The debate is raging, how much the recent weak GDP and employment reports were induced by the unusual weather. But the doubt remains.
On the other hand, there are signs that the European QE is getting traction. The economy is picking up, the fears over the Greek exit are being assuaged, the stock markets are setting records, and the bund yields are rising.
I am not denying the possibility that the relative economic performance of the Eurozone is improving. In fact, I have been bullish on European equities for quite a while. The experience of the QE impact on the stock markets both in the USA and in Japan is very convincing.
But does better economy mean a stronger currency? Counterintuitively, this is not automatically so. Indeed, if a stronger economy causes the Central Bank to raise rates in order prevent overheating, it is reasonable to expect the domestic currency to strengthen.
In fact, we’ve to grown to associate inflation fears with stronger currency, as we are so certain that the central bank would step in with tighter policy.
But what if a central bank is locked in its course?
The Fed has now been following an almost two-year program of tapering/waiting/tightening with very little deviation from the original timeline.
Meanwhile, the ECB had committed to Draghi’s “whatever it takes” and has just embarked on the QE path. It is hard to imagine them changing policy based solely on leading economic indicators, without reaching their formal inflation target.
Paradoxically, assuming that the path of monetary policy is fixed, the pace of growth may be counterindicative to the currency strength. Economic growth increases the supply of domestic currency and stimulates imports. All else being equal, it would lead to the currency decline.
Consider the extreme case: if a central bank maintains a super-easy policy and ignores inflationary overheating, a fiat collapse will be eventually inevitable.
Hence, my view:
- Despite the mixed data, the Fed policy is set to be prudent relative to the growth, supporting the dollar.
- Despite stronger Eurozone performance, the ECB policy is set to be super-easy, continuing to debase the euro.
I am sticking with my short EURUSD position.
Image: “Janus” by Códice Tuna
Chart sourced from Yahoo! Finance