09.08.17

While the euro rises, the dollar and Treasury yields retreat

Brian Nick

Article Highlights

Quote of the week

“The recent volatility in the exchange rate represents a source of uncertainty which requires monitoring with regard to its possible implications for the medium-term outlook for price stability.” – The European Central Bank’s September 7 policy statement

The Lead Story: No news is no news from the European Central Bank (ECB)
 

With the Federal Reserve not scheduled to meet until later this month, markets turned their attention to Frankfurt, Germany, seeking clarity on the ECB’s plans for dialing back its quantitative easing program. Instead, the central bank offered few clues. In its policy statement, which largely matched July’s, the ECB reaffirmed that its asset purchases will “run until the end of December 2017, or beyond, if necessary.” ECB policymakers also treated markets to prose worthy of graduates from the Alan Greenspan School of Central Bank Communications (see the quotation above).  

In his press conference, though, ECB President Mario Draghi provided some newsworthy nuggets, including concern over the euro’s recent rally. In 2017, the common currency has surged 14% versus the dollar, reaching $1.20 on September 8, its highest level since December 2014. The euro has also strengthened considerably against other major currencies such as the British pound (by 7.7%), Swiss franc (6.6%), and Japanese yen (5.9%). 

Although reflecting a number of positive factors—including the Eurozone’s robust economic recovery—the euro’s ascent has hampered the ECB’s efforts to lift inflation. (A rising currency reduces import costs, which flow through to average consumer prices.) Consequently, Draghi announced a slight downward revision to the ECB’s 2018 inflation forecast, from 1.3% to 1.2%. Low inflation should anchor ECB interest rates (currently at 0%) for some time but not preclude the ECB’s tapering of its asset-purchase program.

Meanwhile, currency action has left its mark on equity returns. Year to date through September 8, Europe’s STOXX 600 Index has risen just 6.9% in local currency terms, but the greenback’s slump has amplified that gain to a stellar 21.5% in dollar terms. For the week, European shares (+1.3% in dollars) outpaced the S&P 500 (-0.6%).

September has historically been unkind to U.S. stocks. Over the last 20 years, the S&P 500 has, on average, lost 0.50% during the month. While Hurricane Harvey’s impact may embolden equity bears, we believe the storm’s drag on returns, if any, will be short-lived. In fact, a number of sectors, including home improvement retailers and rental car companies, could actually benefit in the near term. Conversely, cruise lines, as well as restaurants and hotels with substantial clientele in the South, may struggle.

In other news: Market jitters send U.S. Treasury yields lower
 

After falling to a 10-month low of 2.05% on September 7, the yield on the bellwether 10-year Treasury closed a hair higher (2.06%) on September 8. For the year to date, it’s down roughly 40 basis points, confounding widely held expectations that Treasury yields would climb in 2017 given strong labor market conditions, Fed tightening, and the potential for stimulative tax and fiscal policy. 

Among the current concerns reflected in the falling 10-year yield are geopolitical risks such as heightened tensions with North Korea, along with political gridlock in Washington. Additionally, current Treasury yields are an expression of the market’s views on the risks (or lack thereof) of future inflation, the perceived likelihood of central bank actions, and the outlook for U.S. and global growth.

In our view, the week’s drop in Treasury yields primarily reflects slower moves by the Fed and other central banks to raise short-term interest rates amid stubbornly low inflation levels globally. In the coming days,  though, yields should continue to rise as the impact from these idiosyncratic events fade.

Also noteworthy this week was the surprise resignation of highly respected Federal Reserve Board Vice Chairman Stanley Fischer. He will step down on or about October 13, well ahead of the June 2018 expiration of his term.  

His imminent departure adds to uncertainly about the Fed’s future direction, as Chair Janet Yellen’s term is set to expire in February 2018, assuming she is not reappointed by President Donald Trump. (Her reappointment is considered unlikely). As of mid-October, the Board will have four vacancies, unless someone is appointed in the coming weeks. Markets had assumed Fischer would remain to help smooth the transition for Yellen’s successor, and that will no longer be the case.  

Shifts in the composition of Fed leadership carry potentially huge implications for government bond markets, not only in the U.S., but also globally. The Fed has been a beacon of certainty and stability since the global financial crisis in 2007-2009. But now change will bring uncertainty—which financial markets have difficulty pricing in—and we could see direct impacts on currency dynamics and risk assets.

Below the fold: Jobless claims spike in the wake of Hurricane Harvey
 

After ranging between 220,000 and 260,000 for about a year, first-time unemployment claims jumped by 62,000, to 298,000—their highest total in more than two years. A deterioration in certain economic data following a natural disaster is both natural and often transitory, which is why we expect this figure to decline once Houston’s businesses reopen and people can return to work.

The Back Page: Has the common currency become “euro-phoric”?
 

This year marks the fourth time in a decade that the euro has risen by more than 10% versus the U.S. dollar in eight months or fewer. There’s one key difference, though, between the most recent rally and the others: current market sentiment is solidly “pro-euro” rather than solely “anti-dollar.” 

From August 2007-April 2008, the euro climbed 15.3%, to a record high of $1.59, as the Fed cut interest rates in a bid to revitalize a sluggish U.S. economy. Then, from February-October 2009 and June-October 2010, the euro spiked 19% and 15.9%, respectively, amid the Fed’s first two rounds of quantitative easing. This time, instead of the U.S. dollar winning the “race to the bottom,” the euro is catching up to it as both economies grow above their potential.

A combination of the market’s low expectations surrounding a December Fed rate hike and concerns over the eventual start of ECB tapering may mean the euro is overbought in the near term. Therefore, we expect the euro to lose some steam and fall to around $1.15 by year-end.
 
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of TIAA Global Asset Management, its affiliates, or other TIAA Global Asset Management staff. These views are presented for informational purposes only and may change in response to changing economic and market conditions. This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy or sell securities, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor's objectives and circumstances and in consultation with his or her advisors. Certain products and services may not be available to all entities or persons. Past performance is not indicative of future results. Economic and market forecasts are subject to uncertainty and may change based on varying market conditions, political and economic developments.

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