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A wise client of a Swiss bank once argued that she traded currencies not to make money but to earn it somewhere else. Trading currencies enables you to understand relative forces and a wide variety of economic mechanisms. For example, from 2002 to roughly 2011/2013 the rise of BRICs (Brazil/Russia/China/India) was the major driver of currencies as China expanded rapidly requiring many commodities produced by Brazil (e.g. agriculture) and Russia (e.g. oil), benefiting the Brazilian real and Russian ruble. Usually one narrative dominates the others but sometimes they compete creating a complexity beyond the economic reality. Currencies force you to dig deeper in your economic thesis and tend to react faster than equities. Credit may be the canary in the coal mine, but currencies are the weathervane fluttering in the wind on the top of investment houses.
What can we learn from the euro?
The ECB started its hawkish turn and is expected to eventually raise interest rates starting in Q3 far behind the curve. Too much money is floating around while the supply chain continues to be under strain exacerbated by lock-ups in Shanghai’s production hub and large ports. One reason the ECB needs to hike is that the EUR is so weak (see graph), given negative interest rates, that the Eurozone imports inflation (e.g. oil). Another reason is that it is difficult to deliberately maintain a weak currency with negative rates when NATO is in a proxy war with Russia requiring heavy US backing. Even if the ECB turns more hawkish, it will still be running for a while behind the Federal Reserve. Furthermore, Europe’s weaker growth is more exposed to the impact of the overall surge in prices on demand.
Once negative interest rates are gone, the incentive to invest outside of the EUR will be vastly diminished and the odds are that EURUSD should rise somewhat on the back of some demand for European fixed income and much stronger demand for European equities which tend to be bought with low currency hedges (positive EUR).
Two important factors should be steadily at play in the following months
- The secular force of ESG
- A Ukraine conflict that should eventually ebb over many months as Russia finds sanctions and losses eventually unbearable.
Hence, over time European equities should start to regain traction relative to the US in the minds of investors. This is particularly the case as US equities are very expensive. That all assumes that the inflationary and sentiment shock from higher oil prices and Ukraine diminishes in the next few months.
The ECB has a strong incentive to move away from negative interest rates before raising interest rates most likely quite slowly. What may surprise the market is that rates rise to zero much faster than is currently expected, but this does not mean it will continue. We continue to maintain a preference for European equities and the secular force of ESG.