Now that “Le Pen risk” is off the table (at least in terms of the presidency), the market can get back to focusing on the “fundamentals” (scare quotes intentional). “Fundamentals” like what central banks might do.
On Monday, former FX trader Richard Breslow suggested that “the number one question in your mind should be, what, if anything, [the Macron win] means for ECB policy?”
Well on Tuesday, Bloomberg’s Mark Cudmore is out with an admittedly superficial look at policy normalization in the US vs. Europe on the way to explaining why he thinks Draghi and crew might have plenty of room to provide a structural support for EURUSD over the coming years.
As you read everything said below, do remember what SocGen’s Kit Juckes said on Monday: namely that rate differentials likely need to narrow further before EURUSD can move materially and sustainably higher from here.
The Tale of Two Potential Tapers Supports EUR/USD
There’ll be no rapid reduction of central bank balance sheets anywhere. But when the time comes for trimming, there’s reason to believe that the ECB may find progress on this front easier than the Fed. This is contrary to popular perception and, as a result, can provide another structural support for EUR/USD in the years ahead.
- As a percentage of GDP, the U.S. has a much higher total debt burden than the euro zone. The divergence is set to expand rapidly in the coming years because euro-area government debt to GDP peaked in 2014, whereas the U.S’s burden continues to grow
- For as long as the U.S.’s debt profile continues to deteriorate, it’ll be a difficult environment for the major buyer of that debt, the Fed, to step back. Especially if the related signal also lowers the demand from foreign governments
- In contrast, the ECB has the theoretical luxury of being able to reduce its balance sheet while maintaining its percentage of the outstanding debt. The summary is that the Fed is far more constrained in its ability to act
- Of course, this is an overly simplistic way to look at the issue and many other factors will feed central banks’ respective decisions. But it’s an input which is seemingly being overlooked and therefore potentially mispriced in the market
- The euro area has a structural current-account surplus to boot, leaving them more relaxed about external demand fluctuations
- EUR/USD remains about 15% below its fifteen-year average. It seems to me that perceptions consistently diverge from relative fundamentals for both currencies, but in opposite directions. A realignment with reality might see EUR/USD significantly higher in the years ahead