Seeing the Forest for the Trees

The conundrum that everyone is wrestling with is the euro and yen's strength given their negative interest rates and prospect for even lower interest rates. The divergence of monetary policy, even if the Fed is on hold for the rest of this year and next, should be dollar-positive.

We have tried making sense of what is happening by separating the developments into two buckets. The first bucket, and what we think is the medium and long-term driver is the divergence of monetary policy. The German and Japanese yields through eight or nine years are negative. Positive returns are offered in the US. This creates an incentive structure that favors the dollar.

However, something has erupted in recent weeks that has overshadowed these flows. This is the second bucket. It has to do with market positioning. The euro and yen have been used to purchase other assets. This is because the cost of borrowing was low or negative and the currencies were weak or falling. As investors liquidated the assets due to changed views or driven by money management considerations, the funding currency had to be bought.

Another part of this bucket is the unwinding of hedges. Specifically, a popular trade was to buy European stocks and hedge the euro. Japanese stocks would be bought, and the yen hedged. The Dow Jones Stoxx 600 is off more than 16% this year. Italian stock, among the best European performers last year, has fallen by more than a quarter this year. The Nikkei is down 17.5%, and the Topix has fallen 18.3%. The S&P 500 is 11% in comparison.

Until the very end of last year, the divergence of monetary policy was driven not by the Federal Reserve but by the easing of other central banks, including the introduction of negative rates by the ECB. The Fed's rate hike in mid-December suggested to us a new phase in the divergence meme Both sides would be moving. Instead, here in mid-Q1 16, it seems that markets are back to the earlier divergence where the BOJ and ECB are easing while the Fed stands pat (for now).

The circuit of capital flows involving the current positioning (and hedging) is the immediate driver. Market turbulence feeds on itself and compels risk and money management tools. The losses incurred are real and significant. However, prices adjust quicker and more dramatically than the macro-fundamentals, which shape the investment climate over time.

We offer this interpretative framework to make sense of what seems to be irrational Countries with negative yields, like Japan, Switzerland, EMU, Denmark and Sweden have appreciating currencies over the past five sessions, among the majors. Norway, the dollar-bloc, and sterling have depreciating currencies. The US dollar has appreciated against most emerging market currencies. The dollar is not weak even though the euro and yen (and the lesser funding currencies) have been stronger.

We caution against thinking that the strength of the euro against the dollar is a vote of lack of confidence in the US or a vote of confidence in the EMU. In fact, the situation in Europe is deteriorating despite the euro's strength. EC President Tusk says that next six weeks are critical for the refugee problem and Brexit negotiations. This poses existential challenges. In addition, the market developments are fragmenting the European capital markets again. And on top of the North-South divide, Central Europe is diverging from Eastern Europe.

European banks are among the weakest sectors in the equity markets. Partly this reflects another element of divergence. Regarding the disposal NPLs and provisioning for non-performing assets, the US has done a far superior job compared to Europe. European capitalism remains bank-centric, and this remains an obstacle for EMU. The political elite has demanded greater reform for labor than for capital. This is coming back to bite.

In Japan, the record corporate profits were bolstered by the yen's decline. Japanese businesses have not stepped up their capex or shared the windfall with workers. The strengthening of the yen threatens the profit outlook, which was less a function of improved underlying competitiveness and more a result of translation gains (of yen weakness).