Great Graphic: Euro in Past Bear Markets

This Great Graphic was composed on Bloomberg.  It is a monthly bar chart of the real and theoretical euro prior to the launch of monetary union.   The euro is in its third major bear market since the end of Bretton Woods.  

The first bear market is associated with the policy overshoot of Reagan's stimulative fiscal policy and Volcker's tight monetary policy.  The euro's equivalent lost about 58% of its value (white line).

The second bear market is associated with the Clinton presidency and the ERM crisis in the early 1990s.    The euro and its equivalent lost 45% of its value. before the bear market ended (red line). 

The current bear market has seen the euro fall 35% from its 2008 peak near $1.60 (green line).   We expect it to fall 50% from peak to trough before the bear market is over.  This would bring it toward the lows may in 2000. 

The housing market bubble was predicated on the idea that house prices could only rise.  We were told by many that we were at peak oil.  Oil prices would stay elevated as supplies were consumed. Producers borrowed, and banks and investors lent on this basis.  The same logic is unfolding with the dollar.  

For years, many argued that the dollar was in an extricable decline.  The US model of capitalism broke with Bear Stearns and Lehman's collapse.    It was the euro, then SDRs, bitcoins and the Chinese yuan that were going to supplant the dollar.  This thinking, coupled with the low rates in the US (fueled at least in part by QE), encouraged corporations and countries to borrow dollars.  

How much dollar borrowing was there?  The BIS estimates that between 2009 and 2014, the dollar denominated debts of developing countries (bank loans and bonds) more than doubled to $4.5 trillion.   Chinese corporations, many at least partially state owned, have drunk deeply at the dollar well.  Almost a quarter of their debt is denominated in dollar.  In addition to this, European corporates and sovereigns also issued dollar denominated bonds.  

Transparency has been compromised.  Dollars were often borrowed by subsidiaries in offshore venues (think Cayman Islands, Luxembourg, for example).   There is a significant currency mismatch and, admittedly, it is difficult to determine where we are in the adjustment process.  If it took at least five years to amass, is it reasonable to think it has been completely unwound?

We have seen this before.  This is why Fed tightening cycles have coincided with financial crises in other countries, and financial stress on foreign corporations.  The pattern is for them to borrow dollars when the Fed is easing policy and the dollar is falling.  When the Fed begins raising rates, and the dollar strengthens, the currency mismatch is exposed.   The short dollar position must be covered.  The more aggressively it is covered and the faster the dollar rises, the larger the remaining mismatch becomes for those that are not early movers.   

In the past week, the pendulum of market sentiment has swung violently.  From ideas that euro parity is imminent to a number of investors and banks suggesting that the euro decline is over.  The fundamentals are all well known now and fully discounted.   But do markets, and the foreign exchange market in particular, really work that way?  

Economists draw a distinction between flows and stocks.  Stocks are the accumulation of flows.  The US government debt (stock) is an accumulation of annual deficits (flow).  Even if the stock of the dollar mismatch has been addressed, which we doubt, it says nothing about the ongoing flows.    This is to say that the incentive structure of interest rates favor continuing flows into the dollar, on a trend basis.   Interest rate differentials still pay for dollar and sterling based investors to hedge their euro exposure.  Liquidity differences have encouraged US corporations to borrow euros and swap into dollars. 

The key consideration here is the divergence of monetary policy, and the magnitude of this divergence is unprecedented.  The ECB's new aggressive asset purchase program is only two weeks old, and its is expected to run until at least September 2016.  The BOJ's balance sheet is growing 1.4% of GDP a month.   February CPI will be reported later this week, and the BOJ's target rate core CPI, excluding last year's sales tax increase, will be near zero.  This highlights the fact that there is no exit from what the BOJ calls QQE any time soon.  

Meanwhile, it is not simply that the Federal Reserve will raise interest rates long before the ECB (and other central banks), but also the Fed's balance sheet will begin shrinking.  A Fed rate hike is required before the balance sheet will be permitted to shrink.  Making conservative assumptions, as much as 15-20% of the instruments on the Fed's balance sheet will mature or are vulnerable to early prepayment next year.

Last week when asked about this, Yellen was not very forthcoming, perhaps because it is not clear how fast the Fed will allow its balance sheet to shrink passively.  It cannot simply allow this process to be dictated by the market.  The Fed will want to influence the pace.   When pundits say the fundamentals are priced in, what does this really mean in the current environment?  

Currency markets are prone to overshoot, and fair value is subject to great debates.  By the OECD's measure of purchasing power parity (one measure of fair value), the euro is about 17% under-valued.  This fuels some observers to suggest the euro has already overshot.  However, for major currency pairs this is not unusual.  Consider that at the end of the euro's last bear market, it was under-valued by more than twice as much. 

Lastly, we note that the past dollar bull ended not because economists’ measures of fair value were reached, but rather because central banks stepped in and intervened in a coordinated fashion.  This is said not to forecast a new Plaza Agreement (30 years ago this September), but to illustrate the a dollar bull market takes a life on of its own, setting into motion incredibly powerful and complex forces that ultimately sees it climb to heights unfathomable to the uninitiated and experienced alike.