A Good Reason to Be Bullish the Euro (seriously)

Right.

I'm back.

I literally haven't written an article in months.

'Why?' you might ask.

Well what has there been to write about apart from the single most important factor in the market?

What does the market think the Fed is doing?

And what the market thinks the Fed is doing is easily shown below, as Tim has documented with the chart from Quikstrike multiple times over the last few months.

THE ABOVE IS ALL THAT MATTERS!

All the talk of employment, production, inflation, yada yada simply boils down to this when we're thinking of how asset prices might move over the mid term.

I mean, the volatility of the change in interest rate pricing is why equities are off the highs.

See MOVE vs ES below...

As rate vol ticks higher (AND you get the corresponding higher interest rate move, which you naturally would in a hiking cycle), equities fall off, so it's less about the actual basis point shift in rates but the extent of the volatility in them.

I think this is pretty clear and identifiable from the initial Fed Funds term history chart above, right?

The rapid shift in pricing of the terminal rate from Jan through Feb caused the dip in equities and the natural trade to be to sit on the offer.

You might have heard me rant about the macro talking heads a lot, and I was winding myself up with their superfluous Twitter threads covering, well, everything to do with every component of every f*cking part of the US economy, whilst ignoring the simply fact that rate vol is the key component - which is largely why I hadn't been able to be too creative.

Sorry about that!

All of this has been occurring whilst something has been bubbling under the surface in the Eurozone - and of course, it's tightly related.

What are many missing?

Here's a chart of 10 year German breakeven inflation vs US which I stole from FT Alphaville who stole it from Morgan Stanley.

Rather than worry too much about the actual numbers since breakeven inflation can change relatively easily, we should think of this conceptually.

What does this signify?

The Ukraine war has really, seriously, massively caused a change in the structure of German industry.

Rather than have severely cheap gas from Russia to power their corporatist fraudulence, they must seek other sources.

If we were to compare this to the US, who produces a hell of a lot of its own energy, we can maybe see why there could be a significant divergence between the breakeven spreads, where Germany's remains anchored (headline inflation in Germany and the Eurozone is likely to remain sticky off this) and the US' possibly subsides, ceteris paribus (famous last Latin words).

ECB's Holzmann seems to agree too...

What does that mean?

The differential between nominal yields is likely to widen in favour of Germany & the Eurozone...

Which on an FX basis means you probably want to favour the euro over the long term.

I know, that makes for absolutely disgusting reading, but the thing is, the ECB and Eurozone seem to manage to weather every storm thrown at them.

How? I don't know.

But an invalidation on the idea of euro extending higher as we approach flatter rate volatility in the US would be to look for anything indicating German distaste for the project.

Germany is in Deep Shit

Tim wrote this excellent artikel back in October, outlining a few ways in which Germany could be sending itself back to the shadow realm.

And just a few weeks ago, the BASF plant in Germany was shut, with a relocation to China occurring.

One thing that is insanely bleak reading is the lack of trust Germans have in the EU (Europäische Union).

Taken from polling in January...

But the greater issue is the change in dislike of Scholz from the year previous.

Jesus, -24 oercentage point decrease?

He is hated.

And this line is the sum up.

Germany is going through a very odd period of identity change, all because their cheap energy has gone.

If they do start rebelling, that could certainly hinder the euro's grand plans for higher as domestic politics leads to heightened rate vol in the euro area, and some downward pressure from uncertainty.

Euro as a funding currency

As a little aside to this, I want to note how the euro might be changing as a funding currency of emerging market FX trades too.

Where the yields in the EZ have been lower, the euro has been seen as one of the favoured currencies to go to to earn carry.

This JP Morgan piece from early 2020 has an interesting part to note...

'The most obvious events that could trigger an unwind of euro funding include any move towards significant fiscal stimulus in Europe or any move to resume cutting interest rates by the Fed. Both remain plausible, if not particularly likely in the near term based on recent commentary from the Fed and the German government. We continue to monitor these risks carefully.'

Now, obviously we can ignore the continued fiscal stimulus...

But if we do start to approach the terminal rate and the volatility of the Fed funds term starts to slow, this could be a signal to look at buying the euro.

I know, I feel sick saying that too, but we're here to make money, not to f*ck about!