Nervous summer ahead of German election

John Hardy
Head of FX Strategy, Saxo Bank Group

Summary:  Until the dust settles on the German election, USD bears could suffer a "walk in the desert".

The focus as Q3 unfolds will likely shift increasingly to the risk of a post-US stimulus hangover, even if some consumer dissaving could help to drive reasonable, if decelerating growth in the quarter. And so, as we await what we believe will be the macro event of the year, the September 26th German general election, we wonder if the US dollar “see-saw” will see the USD tilting back to the upside and remaining stubbornly strong after a weak Q2. We use the see-saw metaphor because the big dollar bottomed out right at the beginning of Q1, rallied until the end of that quarter and then sold off for most of Q2. In short, USD bears could suffer a walk in the desert until Q4 if things play out as I anticipate. In the meantime, as Q4 approaches anticipation of new stimulus will build in the US and even more so in Europe, as we tilt toward that German election and the future that awaits the EU.

EUR: Can we fast forward to Q4, please? In Q3, Europe will nervously watch the state of German polling as a pivotal general election approaches on September 26th. The election will mark the end of the Merkel era and the beginning of one that either sees Europe lurching slowly toward a new crisis, or one that sees Germany moving all-in on the EU project with a mutualised, climate-driven agenda and massive fiscal stimulus, especially if the Greens score the largest vote tally and see their leader Annalena Baerbock elected the next Chancellor. Polls have been back and forth, with a solid lead for the Greens at one point in May fading in June, but with plenty of time to run until the election.

The stakes for Europe could not be larger, as the “original sin” of the EU remains firmly in place, namely the challenge of multiple sovereigns with only one currency and one central bank. The EU and ECB responded to the Covid pandemic with a dramatic series of measures and the abandonment of budget rules that kept the whole awkward project moving along. We even saw the first introduction of proper EU bonds, even if small in relative terms. But beyond the initial splash of fiscal moves and removal of fiscal restraints, together with the ECB’s new QE purchases under the PEPP programme, the EUR 750 billion recovery fund is peanuts relative to what is needed if the suffocating EM members, especially at the periphery, are to make a more full-scale recovery and dig themselves out of their excess debt and continue to find the will to commit to the EU ball and chain. A strong commitment to the EU from all of its members, dealing with legacy bank issues, harmonisation of reforms and large fiscal outlays, together with a steepening yield curve and positive longer yields across Europe, could engineer a remarkable recovery in the Euro on the other side of this election, if that is the path that is chosen.

USD: Taper talk keeps USD bears on hold until Q4? As I wrote for the Q2 outlook, the best hope for USD bears would be a slowdown in the rise of long US yields—and important long real yields—that marked most of Q1. In our Q2 outlook we noted that “…the most rapid route to the resumption of a US dollar sell-off would be if longer US yields simply cool their heels for a while and don’t rise much above the cycle highs established in Q1, even as risk sentiment and the opening up continue to show solid economic activity and employment improvement in Q2.” That was exactly how the USD weakened; not only did US yields cool their heels, they stayed rangebound all quarter while the likes of EU and UK yields tested new highs, driving solid rallies in sterling and the euro versus the greenback.

But looking back at the last few months, its actually remarkable that the US dollar didn’t fall even more than it did. We had unprecedented USD liquidity from stimulus checks and the US treasury rapidly drawing down its account at the Fed, suppressing US Treasury yields as the liquidity seeks out a parking spot when banks don’t want it to inflate their balance sheets. And the same time the Fed remained seemingly determined to ignore a white-hot economy and inflation. If the USD can’t fall more significantly versus DM peers against this backdrop, when can it fall?

Q3 will likely see no new stimulus checks nor stimulus outlays of note, and infrastructure spending packages seem to get smaller with every round of bipartisan negotiations after Biden tried to impress with the multitrillion-dollar American Families Plan and American Jobs Plan.

In addition, already on June 9th the weekly tally of the Treasury general account had dwindled to $674 billion from over $1.7 trillion in mid-February, so that process is around 80% complete. But as Q3 wears on and the economic recovery decelerates, anticipation of new stimulus will rise. By Q4, taper talk from the Fed could even shift to the recognition that the Fed may actually have to expand purchases to fund the US government if a new series of regular stimulus checks transform into a kind of universal basic income (UBI) beginning as soon as Q4.

We could be too aggressive in this stimulus check forecast or too cautious – it is difficult to tell. US politics is certainly confusing in Biden’s early days. Former President Trump was “Mr. Stimulus” personified and waved the idea of a $2,000-dollar stimulus check in the last days before the November election to win votes—a measure that was actually fulfilled in Biden’s first months as president with the American Rescue Plan, when Biden added $1,400 to the previous $600 check. And now the Republicans are supposed to be the party of stimulus restraint? I don’t think that this is a tenable political position for the Republicans—anti-tax, maybe, but anti-stimulus if the economy is slowing? No way. The realisation that “perma-stimmies” will drive US real rates ever lower, perhaps as early as from Q4, will be the likely narrative for the next major USD move lower.

Chart: US Real Yields and the US dollar. 

The story for the US dollar since the latter part of 2020 has been one of the direction in real yields – in the chart below shown via the US real 10-year yield (the 10-year Treasury yield benchmark less the market’s pricing of 10-year inflation expectations). In late 2020, as the market priced real yields ever lower on an eventual strong surge in inflation on the generosity of US monetary and fiscal stimulus, and after the vaccines showed promising results in early November, the US dollar fell. Then the USD rose in Q1 on the anticipation of the opening up of the economy and as nominal yields rose even faster than inflation expectations. In Q2, the USD fell again as inflation expectations oddly fell even faster than falling nominal yields, all while actual core inflation rose to multi-decade highs. But as we point out, the low yields could be a misleading symptom of excess liquidity in the US financial system; liquidity that could begin drying up in Q3 before the return of stimulus in Q4 that then likely drives real yields and the US dollar lower.

Other FX themes in Q3

JPY: Can real yields ever matter, please? We noted the risk in Q2 that the low EU and Japanese yields might be a risk for the EUR and JPY, as these could stay weaker on yield curve control themes, in Europe implicitly from the ECB’s huge asset purchases, and in Japan more explicitly as it maintains a yield curve control policy. But the performance of the two currencies was dramatically different in Q2. It helped the Euro enormously that US yields stopped rising, and EU yields even teased higher despite the ECB’s heavy hand over the market, helping boost the euro. The JPY, meanwhile, remained passively weak for the quarter despite rangebound and lower US treasury yields after the Bank of Japan opted for an explicit yield corridor (of 0.25% either side of 0% for the 10-year JGB) as a result of its not-so-dramatic policy review at the March 18th–19th BoJ meeting. Meanwhile, CPI data over the quarter continues to show that inflation is non-existent in Japan, so real yields are stable—a solid fundamental support in a world of collapsing real yields elsewhere, particularly in the US where inflation spiked. The distraction for JPY traders may be the attraction of higher yields elsewhere and very strong credit spreads for higher yielding EM currencies in Q2, but at some point,  we would hope that the JPY would get more respect in Q3 and perhaps eventually even more so in Q4 on its still-solid real yields.

AUD, CAD, NZD and NOK. A second guessing of the recovery narrative for much of Q3 could be in order. These currencies could perform indifferently or even weakly after only CAD managed a solid rally on the further rebound in oil in Q2, although the Bank of Canada’s asset purchase taper was a key driver of its most recent leg of strength. AUD is hamstrung by China’s tight policy and deleveraging effort, not to mention direct confrontation on geopolitical issues that has seen China halt certain imports from Australia, including coking coal.

EM currencies – getting much more selective. Emerging market currencies have been a breath of fresh air in recent months as their performances have diverged widely. ZAR has been the strongest currency in EM over the last 12 months, in part on surging mining output for platinum, accompanied by huge rises in the price for that precious metal. MXN hasn’t done too shabbily either as both have seen their current accounts shifting radically to the positive in recent quarters, and Mexico’s left-leaning leader saw his mandate hobbled in the election in Q2. Elsewhere, government policy moves, or the fear thereof, have scared investors away despite strong support from commodity prices. CLP and especially PEN have done poorly on fears that investment flows will shy away from heavy taxation plans for copper producers. BRL and INR were idiosyncratic around Covid outbreaks, and the former still looks attractive from a valuation angle compared to MXN and ZAR, even after a very solid rally off the lows. And TRY is absurdly cheap and could be ready for a rebound if the political and central bank leadership in Turkey can engineer new confidence in their policy mix. On balance, Q3 should see more headwinds for EM as US yields are likely to nudge higher on lower US liquidity and taper talk, and that could accompany a firmer US dollar. Regardless, Q2 was a strong reminder that EM is rich in diverging themes and specific stories—so unlike the monolithic EM carry trades of years ago.

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