Monetary policy divergence to drive currencies
“It is difficult to make predictions, especially about the future,” American baseball coach and philosopher Yogi Berra famously said. A vivid example of this came before us recently when the emergence of a new mutation of the Covid-19 virus destroyed market expectations and sent markets down the world. How can we make forecasts for the next year when the outlook for the global economy is based on random mutants of a virus? Setting expectations is difficult in and of itself in normal circumstances.
But whatever the case, there is somewhere for investors to put their money in. With that in mind, I would like to draw the outlook for the coming year as I see it. And it's not one but two predictions, predictions that the omicron will not be dangerous and significantly affecting the global economy, and other predictions that the omicron - or any other mutation that will be discovered later - will cause damage to our world again. Undoubtedly, this violates the basic rule of prediction whether a prediction is true or false, which is that one should have one point of view and not two. But I have no other alternative this year.
Trendless Dollar
One of the reasons why it is so difficult to determine which direction the US dollar will go is that the long-term trend is hard to discern. Since floating exchange rates began, the dollar has moved in long-term trends that spanned over several years. It is true that there have been long periods of time of movement in the opposite direction (marked in red in this chart) but there has been a long-term trend that can at least be identified. later. However, for several years now the US dollar has been moving sideways. It is unclear whether the US currency has entered a new downtrend which only needs some time to consolidate or if the dollar is still continuing its upward trend that started in 2011. (The chart shows the trade-weighted nominal US dollar index against the currencies developed foreign countries.)
What were we looking forward to before the emergence of the omicron mutant
Let's first discuss predictions like I saw them a week or two ago, before the discovery of the omicron mutant. All in all, the US central bank and its Federal Open Market Committee, which sets interest rates, are very important. The US central bank had promised to "gradually reduce" the volume of its bond purchases, which amounts to 120 billion dollars per month, and after the completion of the abandonment of the bond-buying program, the bank could start raising interest rates. Thus, the questions were when the bond-buying program would end and when the US central bank would then start raising interest rates. Initially, the US central bank intended to end its bond-buying program in June 2022. The debate was whether the bank would raise the interest rate - “start raising the interest rate” - immediately after the completion of the bond-buying program, or whether the bank would be patient And he waits much longer until he can fulfill his mission of "maximum employment", for which the bank has loosely defined "widespread and comprehensive" employment.
The market is starting to assume that the US central bank will raise the interest rate once it ends its bond-buying program in June. In fact, the market is pricing in the possibility that the bank will accelerate the phase-out of its bond-buying program and end the program in May instead of June, allowing a “start-up” to occur in May and be followed by a rate hike again in June.
However, predictions are now much less clear-cut. We do not know for sure how the new mutation will affect the global economy. As Jerome Powell, President of the US Central Bank, said in Latest Certificate Made before Congress:
“The recent rise in COVID-19 cases and the emergence of the omicron mutant poses a downside threat to employment and economic activity and increases the uncertainty over inflation. Exacerbated concerns about the virus could reduce people's desire to go to work, slowing progress in the labor market and exacerbating disruptions in supply chains.
Slowing economic activity? High inflation? How will central banks act?
Making predictions for the next year right now reminds me of the story of a man driving his car lost in the countryside. This man stopped to ask a farmer which way he should take to reach his destination. The farmer replied, "Okay." "If I am you and I want to get there, I shouldn't start from here," he added. But just like a motorist, I have no other choice because these are the possible roads ahead.
Starting point: agreement and divergence between monetary policies
Carry trades, in which an investor borrows money in a currency with a lower interest rate and invests in a currency with a higher interest rate, is usually one of the driving forces in the forex market. In the aftermath of the 2008 global financial crisis, carry trades became less profitable and attractive to investors after central banks around the world cut interest rates together. In the wake of the Corona pandemic and after interest rates became close to zero, the carry trades between the G10 currencies have largely disappeared.
This year, the most important thing for the markets was trying to determine the pace of divergence in monetary policy between different countries. So how quickly will central banks start raising interest rates and how far will interest rates go? The agreement in monetary policy has changed and moved in the opposite direction, and we have witnessed the beginning of divergence in monetary policy as it was expected that a number of central banks would raise interest rates at a different pace. This difference has been the reason for more than half of the change in currency rates this year.
Omicron turns out to be gentle and not dangerous
In the good case, if the omicron turns out to be not much worse than what we're already experiencing, I'd assume that the world will continue pretty much the way it intended before this latest wave of omicrons appeared, but with a greater degree of caution.
This assumption appears to be what the markets are already assuming now. After the virus was discovered, interest rate expectations were revised downward in most countries (except for Japan, which was basically not expected to raise rates). However, it is still positive. People are just assuming the pace of monetary tightening is slower and less profound than they previously expected, but without a complete deviation from the trajectory.
That may be true, not only because of pandemic fears but also because inflation may not rise as much as expected. Inflation expectations have recently started to decline in most countries (Britain is the main exception).
I stand firmly in the "temporary" camp, even if US Federal Reserve Chairman Jerome Powell said recently This word should be 'dispensed with'. Most of the recent increases in inflation are due to the impact of the pandemic. It is true that it may take longer than expected for inflation to return to normal levels (hence the idea of dispensing with the term “temporary” inflation), but I still expect the global economy to gradually adjust to the “new normal” and that inflation will decline in the year next by itself.
Like most forecasters do. With the exception of a few countries (the most important of which are Britain, Japan and China), the inflation rate in most countries is expected to be lower in 2022 than it was in 2021.
Starting point: the US central bank and the dollar
We'll start with the US central bank, for two reasons. First, because the actions of the bank affect the dollar, which is the standard against which all other currencies are measured. Other central banks will be reluctant to raise interest rates much more than the US central bank for fear of appreciation of their currencies, which will in turn inflate restrictive monetary conditions. Second, the US dollar is not only the sun around which other currencies revolve, but also the US Treasury market uses its gravitational force against all other markets for interest rates. If US bond yields rise then bond yields in other countries often rise as well, albeit at a different pace, and it is these differences that create opportunities to invest in the forex market.
The question that arises is, when can the US central bank “start to raise interest rates”? In the testimony given by US Federal Reserve Chairman Jerome Powell to which we referred in the previous lines, Powell said “there is still some distance to go until we reach the maximum employment limit in terms of both employment and labor force participation, and we expect continued progress.” It is true that the unemployment rate, currently at 4.2%, has returned to the level it was in a few years ago, but the participation rate is still well below the normal level.
In the FOMC's quarterly report, "Summary of Economic Outlook," the committee estimated that the "maximum employment" would be reached at an unemployment rate of about 4%, while most other estimates range between 3.8% and 4.3%.
Some believe that the US central bank is likely to be patient and delay the rate hike until the labor market returns to the state it was in before the Corona pandemic, that is, an unemployment rate of 3.5% and a participation rate of 63.3. However, I think they are likely to accept the idea that the structure of the US labor market has changed and that it is not likely to return to those levels any time soon, especially the participation rate because there has been a fundamental change in people's desire to work. As a result, I think they will agree to "start the rate hike" with the unemployment rate close to what they see as the long-term level.
In addition, they can argue, as they did in the past, that letting go of accommodative monetary policy is different from tightening monetary policy. Their estimate of the long-term neutral level of the fed funds rate has held steady for the past three years at 2.5%. Under this estimate, a rate hike to 0.50% or even 1% would not be monetary tightening but merely introducing less monetary easing. Following this metric, it would make a lot of sense to start raising the interest rate even before the "employment cap" is reached.
Predictions for the dollar: a two-stroke game
Based on that, I'll split the year into dollar halves or halves. In the first half, I think the dollar is likely to be supported by expectations of a rate hike in the US. But in the second half, I think the market could be disappointed by the slow pace of actually raising interest rates. In addition, by that time I expect inflation to fall and the urgent need for an interest rate hike to be reduced.
After the first rate hike, whether in May or June, I expect to see statements along the lines of the following, which followed the last rate hike in December 2018: “…the Committee will be patient as it determines what future adjustments to the target range of the fed funds rate will be.” which may be appropriate to support these findings.”
If we look at the latest rate hike cycle, which started in December 2015, it is clear that it has been much slower and less deep than previous rate hikes. This corresponds to a gradual decline in what members of the Federal Open Market Committee believe is the neutral Fed funds rate.
I think the next cycle of rate hikes is likely to be slow and shallow, if not more so. However, the futures market (dotted line) rules out a more rapid rate hike. I believe that once the US central bank starts raising rates, we will likely see the traditional reaction of “buy on rumours, sell on facts” and the dollar could weaken in the second half of the year.
There is another possibility, albeit that will lead to the same result, which is a sharp rise in the dollar in the first half of the year and possibly a sharp decline after that. That is, the US central bank could decide to tighten its monetary policy sooner and faster than expected. “The economy is very telling and inflationary pressures are high,” Jerome Powell said in his testimony to Congress. It is therefore appropriate, in my view, to consider ending the tapering of asset purchases...perhaps a few months earlier than expected.” This could mean that the dollar is likely to rise in the first half of the year, perhaps more than I expect, but then fall back in the second half of the year because other central banks will also raise rates, following in the footsteps of the US central bank.
There are other factors that could in turn lead to a weakening of the US dollar by the end of the year. At the forefront of these factors is the widening current account deficit. I think the current account deficit could be even wider than the market expects because with supply chain bottlenecks resolved it is likely that American citizens will go back to doing the thing they are best at ever: spending, spending, spending. And a lot of the goods they spend their money on are goods imported from abroad. It should be noted that the current account deficit reached 5.8% of GDP during the 2006/07 boom before the collapse of Lehman Brothers, a figure close to double the forecast for next year of 3.3%.
Meanwhile, the capital flows that helped finance the United States may slow. The dollar has recently received support due to the huge inflows into the US financial markets, especially in light of the fact that the US stock market has outperformed other markets at the global level, but in light of the high US valuations compared to other countries and many of the leading companies in the technology sector that Driving the rally is threatened by new global rules on corporate taxation, the US market could become less attractive next year.
There is also a risk that the virus will hit the United States harder than other countries. See below for more details on that.
Other currencies
The first step when evaluating currencies is always purchasing power parity. How cheap or expensive are coins? To assess this, we compare the current exchange rate with the Purchasing Power Parity (PPP) estimate for different currencies made by the Organization for Economic Co-operation and Development.
A set of results will appear. The Swiss Franc is (as always) relatively overvalued, but less overvalued than usual. It can still rise. The valuation is fair to the Australian dollar, the New Zealand dollar and the Canadian dollar and not far from the normal valuation; These currencies can move in either direction, up or down. The British pound is significantly undervalued, but this is likely to be a permanent change due to Britain's departure from the European Union; This is now broadly in line with the currency devaluation it has experienced on average since the Brexit vote. The Japanese Yen looks cheap, the Euro looks very cheap. It is at the -20% line which in the past has often led to a devaluation just enough to improve the trading account and thus push the value up again.
In short, it is likely that the valuation is not an obstacle to movement in either direction for most currencies except the EUR. The downside move for the EUR may be limited from here.
Let's look at the currencies one by one. For each of the currencies, we'll start with a market forecast from Bloomberg, which includes estimates of the rise and fall of each pair. Please keep in mind that the ups and downs may only reflect the view of one forecaster, while “average” refers to the expectations of most forecasters. However, the two extremes give you an idea of where the risks are and what the possible moves are.
Euro: slow catch-up with the US central bank?
Apparently the market is assuming that the European Central Bank is heading towards tightening interest rates, and these assumptions are gradually pushing the Euro higher.
However, I have the following notes:
- Inflation in the European Union is not expected to rise as much as in the United States. In fact, inflation in the European Union was not expected to be as high as it has in the United States for years now. In addition, inflation expectations remain within the ECB's target range, while in the US they are above the US Central Bank's target range.
2. The US used to raise interest rates before the European Central Bank did. If we compare the last round of monetary tightening in the US and Europe, we will see that the US moved much faster. (We will ignore the short-term tightening cycle in Europe that began in April 2011 and only lasted seven months before the ECB realized it was a huge mistake.)
3. The situation of the virus outbreak in Europe is currently much worse than in the United States. This may delay the quantitative easing and monetary tightening in the EU as more European countries enter into lockdown and slowdown in growth.
But the virus problem could also have a negative impact on the US dollar. The United States is in a singularly bad position when it comes to fighting a new, more ferocious breed, for two reasons. The first reason is that the reaction is not at the national level of the state, but rather on a state-by-state basis. Nearly half of US states are controlled by the Republican Party, whose members see it as their patriotic duty to ensure that Americans are free to die of the coronavirus if they wish. The second reason is that the United States has the lowest rate of coronavirus vaccination among developed countries, ensuring that they will have the opportunity to do so. This is a huge risk that the United States and the US dollar will face during the first quarter of next year.
JPY: The JPY Returning to Carriage Trading?
Market expectations are for a lower Japanese yen in 2022, and I agree. The only thing is that I think the currency is likely to fall more than market expectations. However, please remember that my daughter is studying at a university in Japan, and for that I am naturally biased towards the hope of a depreciation of the Japanese yen, so I may not be a hundred percent objective.
Why are forecasts pointing down? This is probably because Japan is supposed to lose in the race to normalize monetary policy. Over the next two years, interest rate hikes are expected even in Switzerland and the Eurozone, but not in Japan.
Most likely this is because the country's inflation rate is expected to remain well below the BOJ's target of 2% two years from now.
Ultimately, the BoJ may have to adjust or even raise its “yield curve control” program, which keeps the 10-year JGB yield at ±25 basis points greater or less than zero. However, this meeting may not be the right timing even as other central banks move to normalize their monetary policy. The Deputy Governor of the Bank of Japan, Imamiya Masayoshi, delivered a speech entitled the politicianThe economic and monetary situation in Japan, In which he said:
“Sometimes they ask me if Japan needs to adjust monetary easing because central banks in the US and Europe have recently started moving towards adjusting their monetary policy. [...] Given my description of price developments in Japan, I think it makes sense that the BoJ does not really need to adjust broadband monetary easing at the moment. Central banks use monetary policies in line with developments in economic activities and prices in their respective economies. Therefore, it is natural that the details and directions of their monetary policies are different from each other, and this difference will lead to stability in their economies and also in the global economy.”
What Imiya Masayoshi said was not a joke. The case of inflation in Japan is categorically different from that of other countries, and even with low inflation Switzerland. Thus, monetary policy must also be different.
In short, I think the BoJ is likely to keep monetary policy on hold while other central banks raise interest rates and monitor the bond markets' response accordingly. The widening spread of bond yields between Japan and other countries is likely to be a magnet that attracts money from Japan and weakens the Japanese currency.
Accordingly, I believe that Japan is likely to be the financing currency of choice for the next several years. In my view, the return of “JPY carry trades” is likely to lead to a return of JPY weakness. (The term “JPY carry trade” refers to the late 1990s when Japanese interest rates were much lower than their counterparts in any other country and people all over the world were borrowing money in Japanese yen to finance anything and everything, and this weakened the yen more Japanese.)
In addition, the Bank of Japan continues to implement a “control yield policy” in which it limits the movement of the Japanese 10-year government bond yield to ±25 basis points greater or less than zero. As other central banks raise interest rates, bond yields in those countries are likely to rise. Not Japan! Therefore, with the widening of the spreads between the returns, it is likely that Japanese investors will continue to invest more money abroad, which will push the currency lower.
However, the important question that arises is: Will the Japanese authorities change their view? So far, the Japanese Ministry of Finance has been focusing on encouraging exports and prefers the Japanese Yen to be weak against other currencies. Now with Japan running a trade deficit though they may be more interested in ensuring affordable imports and don't want the JPY to weaken further. Verbal intervention from the Japanese authorities could reduce the downside of the JPY (or reduce the upside in USD/JPY, to be more precise).
But the real value of the Japanese yen against the currencies of Japan's major trading partners (Real Effective Exchange Rate, REER) has not reached the level that would normally indicate an improvement or a turning point.
Another factor that mitigates the downtrend of the Japanese yen is positioning. The Japanese Yen has been the number one selling spot for speculators for several months now. Only the Australian dollar has recently replaced it. Perhaps the reason is that there are not many people who want to enter into deals.
Prediction Risk: With global inflation rising, inflation is likely to rise in Japan as well. It is reported that Japan's Corporate Goods Price Index (which is referred to in the rest of the world as the Producer Price Index) has been rising steadily in recent times. The index read 9% year on year in November, the highest rise for the index since 1980. The producer price index for finished goods recorded the highest rise since 1981.
This increase in the reading of the index was led by the rise in the prices of raw materials which have already recorded a huge increase - up by 74.6% on a yearly basis. This is the highest rate of increase since the oil shock in 1974. Intermediate goods are up 15.7% year over year.
And if companies get tired of absorbing high producer prices in their pricing, then we may see inflation return to Japan after an absence of nearly 30 years. This could lead to a drastic change in the Japanese economy and monetary policy - and the Japanese yen.
Sterling: The 'Welcome a Coyote' moment?
I have to admit: I hate sterling. I think it should definitely be on par with the Euro - and with the Italian Lira if it still existed or maybe with the Greek drachma (well that was a bit of an exaggeration because if it existed now a US dollar would be worth about 301 Greek drachmas) . But still, Sterling to me is like a Will e Coyote in the Road Runner cartoon running off a cliff and running until the moment he lights up…
All forces seem to have united against sterling:
The country's current account is constantly in deficit, due to the structural deficit in trade in goods. Oddly enough, Britain's departure from the European Union may have improved this performance somewhat. European Reform Center Foundation You can That Britain's departure from the European Union reduced Britain's trade in goods by between 11% and 16%. If we assume that imports and exports are affected to the same degree, then since imports are greater than exports the trade deficit should be somewhat narrower (although the effect on the exchange rate may be offset by the fact that the effect on the economy as a whole will be smaller as a result.)
Britain relies on trade in services to make up for the deficit in trade in goods, and we are facing an “Achilles heel” of the economy. The blow could therefore be even more deadly because eliminating an entire business in the service sector is much easier than eliminating an entire business in goods. For trade in the service sector, the decline in trade is caused solely by the cost of carrying out paperwork. Some companies will find it worthwhile to pay while others will not. But in the service sector, if one country refuses to license companies from other countries to carry out certain services (such as managing assets or selling insurance), then the result is a crash! The entire business ends.
Unfortunately, Bloomberg does not provide a detailed breakdown of where Britain's service sector exports go, but I imagine a large proportion goes to the EU, similar to UK merchandise exports (so far) of 51.5%.
The United Kingdom and the European Union have yet to agree on the details of their trade agreement regarding services, but Britain's departure from the European Union has already led to a 5.7% drop in services exports, according to a recent research paper on Britain's departure from the European Union and trade in services. The paper also stated that “since liberalization of trade in services is generally more difficult than liberalization of trade in goods, it would be extremely difficult, if at all feasible in any way, to predict that future FTAs will provide access to new markets in a meaningful way. Ultimately, the attractiveness dictates that trade in services is usually larger with the closest trading partners.”
We must now wait and see if British Prime Minister Boris Johnson will activate Article 16 And he succeeds in destroying the entire agreement to separate Britain from the European Union, which took a very long time to reach in the first place. Of course, it has always been impossible to resolve the difficult question of Northern Ireland: an agreement that would allow Northern Ireland to be part of the European Union and the United Kingdom at the same time. Northern Ireland is not like a quantum qubit [a particle that can exist in two different states at the same time].
Since services not only constitute a large part of Britain's trade, but also 80% percentage of economic activity And 82% of employment, a failure to reach an agreement on trade in services would be very damaging to Britain.
Where does Britain's income from services come from? About half comes from direct investment, while the other half comes from investment in portfolios.
Direct investment has seen a significant contraction since the Brexit referendum. I expect it to see more contraction in light of the continuing tension between Britain and the European Union and the internal problems facing the British economy.
As for investing in portfolios, most of it is in stocks.
The UK stock market is the only stock market among the major global stock markets that has not yet risen to its pre-pandemic highs in US dollar terms. (This is not just due to the currency’s valuation – the FTSE 100 index of the most important and largest stocks also did not reach its pre-pandemic levels in terms of value in local currency, although the FTSE 250 index, which includes mostly local companies, did.)
So now we can say that UK stocks can be a good investment because they are likely to catch up with their peers in the rest of the world… But if you were a fund manager, would you bet on leaving your career if that didn't happen? Everyone in the financial field knows that “past performance is no guarantee of future performance.” Meanwhile, everyone also knows Newton's first law of motion which states that “a moving object remains in motion unless acted upon by an external force.” What external force will change the course and direction of British stocks? I don't see anything good that we could see happening any time soon. The current administration may eventually implode and the prime minister be replaced by someone who knows, or knows, exactly what to do. But this will take some time, and in the process the market is likely to experience a lot of sharp volatility.
This allows high-yield British government bonds to attract money. As UK bond yields are now heading towards the lowest level for G10 government bonds, this will require a significant rise in interest rates - one that the Bank of England likely does not want to see in these critical times. Accordingly, I expect the British Pound to bear all this pressure and adjust downward until UK assets become more attractive to international investors.
The main point of view that could go against mine is that the British pound has already suffered quite a bit, and any other issues are already priced in the price. not necessary! The real effective exchange rate of a currency only indicates the average at the moment. And any new drop of 10% on this scale would be nothing uncommon.
In addition, Britain's separation from the European Union led to a contraction of the British economy. It is estimated that even before Brexit the economy contracted by 1% to 3% due to a rebound in consumption and investment (as well as the devaluation of the pound). The government estimates that the economy will contract by between 4% and 5% by 2030. Slower growth means that productivity increases will also be slower and the incentives for foreign investment in the country will be lower, all of which have a negative effect on the currency.
Commodity Currencies: Australian Dollar, New Zealand Dollar, Canadian Dollar
Does it make sense to treat all three commodity currencies together? I think so. Correlations between them are somewhat high from a historical perspective, particularly between the Australian and Canadian dollars. This indicates that the market holds them all together to a large extent.
Their fate is largely determined by what happens in China. After the recent monetary policy easing there, which included two cuts in the reserve requirement ratio for banks operating in China, it is a good sign of future growth in China - and thus the global manufacturing cycle.
This should also help support global metal prices, which are one of the main factors in determining the value of the Australian dollar.
Since food makes up 62% of New Zealand exports, one might assume that world agricultural prices are more important to New Zealand than mineral prices, but one might be wrong (except for milk). The New Zealand dollar, according to my research, correlates with commodity prices in general and even energy prices even though New Zealand does not export oil or coal as much as it is agricultural commodities. I believe that the forex market is not much different than before and that traders only think of “commodities” without necessarily thinking about what those commodities are.
As the economic cycle turns, commodity prices should rise faster than manufactured goods prices, which should improve trading conditions for commodity currencies and allow them to rise.
Of course, this dependence on China is a double-edged sword. Monetary and fiscal stimulus has become less effective in generating growth in China, thanks to the miracle of diminishing marginal returns. With the real estate sector suffering serious problems in China, growth in China could also suffer from more problems than the government can contain through monetary intervention.
He mentioned a recently published research entitled (The peak of the housing sector in China, which was conducted by Harvard University professor Kenneth Rogoff and IMF economist Yuanchen Yang) that “in 2016 real estate and construction combined accounted for about 29% of China’s GDP, a huge proportion that is matched only in Spain before the crisis and in Ireland... Real estate not only accounts for 23% of household consumer spending in China but is also linked to various sectors of the economy through investment, construction and the financial system. These two economists estimate that “a 20% drop in real estate activity in China could lead to a 5% to 10% drop in the country’s GDP, even without a banking crisis or taking into account the importance of real estate as collateral.” This leaves the Australian and New Zealand dollars vulnerable to a fall in the event of a downtrend in the Chinese construction sector which, if evergrand is an indicator, looks possible if not likely.
The other side of vulnerabilities for commodity currencies, particularly the New Zealand dollar, is if the market begins to reassess the potential degree of monetary tightening over the next year. Since the New Zealand dollar has the most tightening already priced (followed by the Canadian dollar), if investors begin to believe that central banks are unlikely to raise rates as strongly as expected at the moment, the New Zealand dollar is likely to experience the largest adjustment For estimates, it is followed by the Canadian dollar. This will also negatively affect the currencies.
Canadian dollar: Watch out for oil
It is true that the Canadian dollar is classified as a commodity currency, but its fate is closely linked to only one commodity: oil. There is a very high correlation between the USD/CAD pair and the Central Bank of Canada's Energy Price Index (which is made up of coal, oil and natural gas prices).
The oil industry seems to have agreed that the price of oil is likely to fall next year because supply is increasing faster than demand (see below). If that happens, I expect the Canadian dollar to fall a bit. The Canadian dollar has been the best performer of the three commodity currencies this year, and indeed the best performing currency among all the G10 currencies (and even slightly higher against the US dollar). But assuming steady growth in China and low oil prices, the Canadian dollar may be the worst performer of all among the three commodity currencies.
Switzerland: Part of freedom from the pandemic
The EUR/CHF fell to its lowest level since June 2015 a few months after the Swiss National Bank (SNB) dumped the franc rate cap against the Euro (it happened in January 2015). What happened to the repeatedly reiterated pledge by the SNB board that it “remains ready to intervene in the foreign exchange market as necessary, in order to counter the upward pressure on the Swiss franc”?
There is no doubt that the Swiss franc is still overvalued - in terms of purchasing power parity as it is the currency that ranks first in the world in the list of overvalued currencies, both according to the calculations of the Organization for Economic Co-operation and Development and based on the Beige Index Mac" The Economist's "Less Scientifically Important" magazine. However, there are some doubts about the SNB's willingness to intervene in the forex market. As the chart shows, the SNB has been much less involved this year at every level of the EUR/CHF than in previous years.
The SNB may be happy that inflation is back at 1.5% and therefore see no need to intervene as much - although some would say that given the abnormally high price level in Switzerland the country needs deflation rather than inflation.
Perhaps the bank thinks it's inevitable, given the way the Swiss economy has outperformed the eurozone economy since the coronavirus pandemic began.
One of the reasons why the Swiss economy has performed better than the Eurozone is that Swiss exports have proven resilient and not affected well, leading to a high trade surplus.
The EUR/CHF is largely following in the footsteps of the Trade Balance.
The yield advantage of Swiss franc-denominated bonds versus German bunds (or more precisely the disadvantage of German bond yields over Swiss franc-denominated bonds, since they are both negative) has diminished considerably this year. This was supposed to make it easier for the Swiss to recycle their trade surplus by investing in portfolios.
But investing in portfolios abroad is only a small part of the surplus recycling in the Swiss trade balance. Direct investment is usually greater, but the Swiss have stopped direct investment abroad due to pandemic conditions. Meanwhile, the SNB refrained from intervening (as mentioned above).
What will happen? I agree with market expectations that the EUR/CHF will rise (the Swiss Franc will fall against the Euro), mostly because I believe Swiss companies will resume investing abroad. In addition, as interest rates normalize around the world, I would expect the “other investments” category – which includes loans – to move into capital outflows as investors use the Swiss franc as a funding currency (along with the Japanese yen). And while Swiss franc rates are expected to rise a bit faster than euro rates (which I can't easily understand, but don't care), given that they will start at 25 basis points lower than the euro rate, the The Swiss Franc can rise a little faster and at the same time the interest rate on it remains lower than the interest rate on the Euro. This will make the Swiss franc a good financing currency.
Oil: a two-stroke game
Why is OPEC+ doing this? The group expects - and by the way with the approval of the United States - that the oil market is likely to see an increase in supply next year and that prices will decrease. On Thursday, the Council of the Organization of the Petroleum Exporting Countries, a group of economists who advise the organization, warned that the increase from various sources of strategic oil reserves, which is likely to total 66 million barrels, would lead to the growth of a surplus in the crude oil markets. Global 1.1 million barrels per day to 2.3 million barrels per day in January and 3.7 million barrels per day in February. This is a difference in degree, not direction, from the expectations mentioned in short term energy forecast The US Energy Information Administration issued a December 7 forecast that “growth in OPEC+ production and US and non-OPEC shale” will outpace the slowing growth in global oil consumption, particularly in light of renewed concerns about COVID-19 mutants. As a result, the United States expects the average price of Brent crude to average $71 per barrel in December and $73 per barrel in the first quarter of 2022. For 2022, it expects the average price of Brent crude to average $70 per barrel.
But as we go further, the predictions become less reliable. Both supply and demand become uncertain and ambiguous. The demand is because we don't know what the impact of the virus will be. Will the virus go away or will it get worse? If the effect wears off and countries lift their restrictions, then demand is likely to return to normal (or over).
As for the show, there are many things that remain unknown. It is true that the OPEC+ group is supposed to increase its production by 400,000 barrels per day each month, but the group may not be able to achieve this goal because most members of the OPEC+ group are already imposing significant capacity constraints and may not be able to increase their production. Among the OPEC members, only Saudi Arabia, the United Arab Emirates and Iran have significant spare capacity. In order for the OPEC+ group as a whole to reach its production target, Saudi Arabia and Russia should significantly exceed their respective production quotas which may not be welcomed by other members.
Second, there is a big question mark about Iran's production, which currently stands at 2.52 million barrels per day or 9% of total OPEC production. If the Biden administration reaches a deal with Iran - something that seems increasingly unlikely - Iran could be free to sell more oil. Iran has the capacity to pump 1.3 million barrels per day, which is a large amount that could change the equation dramatically. But if they don't - which seems likely to happen - their ability to maintain the oil fields will likely be reduced, leading to reduced production. The same goes for Venezuela, which is also subject to a US trade embargo.
Finally, there is the question of US production which has not yet returned to pre-pandemic levels. This could also change the supply/demand picture by 1 million barrels per day without the complicating factor of multinational negotiations.
I think that in the second half of the year, after economic activity returns to normal (assuming economic activity returns to normal in the first place!) oil prices could rise further.
The sad truth is that high oil prices are indispensable to achieving another goal of President Biden, which is the transition to renewable energy. Nothing can encourage investment in windmills and solar panels more than $100 a barrel of oil. Not to mention that higher oil prices will be necessary to offset the risks associated with further exploration and development of long-term oil projects on the back of mounting pressures from the ESG movement to move away from fossil fuels. Otherwise, there is a risk of a significant price hike sometime in the decades before the transition to renewable energy is complete. As they say in the oil trade, “high prices cure high prices”.
Footer: How accurate are market forecasts?
In this article, we have used market forecasts from Bloomberg for the major currencies. How accurate are these predictions? It is impossible to know the answer to this question in advance prematurely. However, what we can do is compare the forecast movements with the previous year's forecast movements and ask ourselves the following question: Are these forecasts reasonable and acceptable?
What we can see is this: For all currencies, except for the New Zealand dollar, market expectations were for a move below the year average.
It is certainly not impossible, but is it possible? In fact, currency volatility has been declining over the past several years. Volatility rose again due to the Corona pandemic but has since decreased. It is very possible that we will see a year with lower than average volatility. But again we say that in 2020, we did not expect to be exposed to a pandemic
global, isn't that right?
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