FX: "Moving Toward September"

From Marc to Market, Aug. 6:

The release of the US employment data before the weekend ushers in a three-week period before the Jackson Hole confab at the end of the month that will start the new phase. In September, the FOMC is likely to announce that it will begin not fully rolling over the maturing proceeds of its swollen balance sheet. The ECB will probably announce that it will continue to expand its balance sheet in the first half of 2018 albeit at a reduced pace.

There is a small possibility that the Bank of Japan raises its target for 10-year JGB yield from zero to 10 bp. UK Prime Minister May is expected to deliver an important address on Brexit. Germans are expected to give Merkel a fourth term as Chancellor. Electoral considerations seemed to limit the EU issues that the German government was willing to entertain. When the election is out of the way, Merkel may perceive having greater flexibility to address EU issues.

Perhaps the fundamental case for the euro was more compelling than we appreciated in Q2. As we anticipated, the populist-nationalist assault would not secure a beachhead in Europe. When combined with the continued above trend growth and a spike in inflation, it forced investors who had become underweight European exposure to scramble. After selling about 100 bln euros of European equities in 2016, foreign investors returned around a third in H1 17.

At the same time, skepticism increased that the Trump Administration can deliver its economic agenda. At the same time, US data consistently underwhelmed expectations, and core inflation fell. There were a couple of jobs reports that in hindsight proved to be quirks rather than signs of a dramatic weakening of trend, but at the time, contributed to skepticism over the trajectory of monetary policy.

Neither the technical nor macro economic considerations are as compelling. It is true that the political climate in the US leaves much to be desired. This does not seem likely to change anytime soon. However, what is changing in European politics. Just like the consensus was slow to recognize and appreciate that the fragmented multiparty political systems act as a bulwark against populist-nationalism, it is slow to see the underlying contradictions within Europe are unresolved and could re-emerge quickly.

The wave of optimism in Europe and among investors in response to the French elections was not simply about the turning back the National Front, but it was also the possibility of renewed Franco-German cooperation, which had seemed to wither on the vine in recent years. This project was recognized as all the more important given the UK's decision to leave the EU and seeming unilateralist (not isolationist) thrust of the US. The necessary precondition is that the France had to regain the authority to do so by getting its own economic and fiscal house in order....MORE