Thoughts on EUR for January 2023, from Alex Castaldo

I do not focus on foreign currencies in my trading. And there are people here, such as Mr. John Floyd, who are far more knowledgeable about FX. So some of you may find these thoughts a bit simplistic; keep in mind I am an amateur!

I believe that a factor that makes a country's currency attractive to investors is the success (or lack thereof) that foreign investors have investing in the country in question. We can gauge this success by using ETF's that specialize in particular countries. For example SPY measures the performance of stock investors in the US, while EZU tracks investing in Eurozone stock markets.

What do we see? In recent months EZU has been performing better than SPY. For example in the last 6 months of 2022 SPY had a total return of 2.03% and EZU 9.56%. For 2022 as a whole SPY -18.38% and EZU -16.67%, two ugly numbers, but EZU did better. (These numbers will change between now and Dec 31, but not by much).

In my view this kind of comparison (especially given that Europe did poorly the previous few years, so it's a remarkable turnaround) will attract additional US investors to Europe, strengthening the currency. That is why I am bullish on EURUSD for the month of January 2023.

Bud Conrad responds:

Your logic is that if the stock market of a country rises, the currency of that country will rise in exchange rate. In the early days of this Speclist, the chair would ask me if I had "counted" the historical experience, which you cite for the last six months and year, but usually you need something like three cycles of inflection to get confidence.

The more usual comparison for currency strength are the Interest Rate Parity, using the futures market expected exchange rate and the difference in Interest rates.

And there the International Fisher Effect, also described here.

Often international traders look at trade balances for the country that has a trade surplus to be more attractive so the currency might rise. Trade surpluses mean they are a lender and not in debt to other countries. The US is the world's largest debtor, but the currency has been doing well.

John Floyd writes:

Doc makes the broadest, cleanest, and most accurate point about what drives currencies: what are expectations for return by BOTH domestic and foreign participants, and how does that drive investment flows into equities, FI, FDI, etc, which shows up in the BOP and Capital Account - on the other side of the ledge is the Current Account and the Errors and Omissions.

Admittedly I don’t know much about currencies and this is the area I know least about, but flow data is well researched and document by many at banks, independent research firms, IIF, IMF, BIS, etc. One challenge is it is often very much lagged, so Doc’s idea of looking at actual market instruments makes sense, and this is often particularly useful for emerging markets.

Capital account flows can fund a current account deficit for a very long period of time. Look at the US now or look at the Asian Currencies pre the crisis: errors and omissions become important given capital flight, particularly EM. Think Russia pre ’98 and Swiss bank accounts, etc.

As Doc well knows infinitely better than me, we need some more data and this can all be tested.

More broadly, outside of equity flows, Bud’s point of interest differentials will drive some capital flows. Also consider FDI from Europe to North America to diversify dependence on European energy costs and to friend shore manufacturing capacity.

And I would be remiss to not mention Italy (sorry Doc). Italy is in a Euro straightjacket that not even Houdini could get of. ECB is tightening with inflation at 10%, Italy 150% debt to GDP, Italian per capita GDP is barely higher than when joined Euro in 1999, Italy needs circa $250 billion in funding in 2023, 10 year yields in Italy up from 1 to 4.5%, all Italy issuance past few years was essentially bought by the ECB. This is not politically sustainable. Just look at the evolution of recent German politics. The ECB’s TPI is there but is intended for temporary dislocations and will require Italian political concessions. Oh and Italy is 10x Greece and the world’s 3rd largest sovereign debt market behind the US and Japan.

Bud Conrad writes:

Excellent points John, about the importance of needing immediately updating indicators to guide trades Fund flows definitely underpin thee attractiveness of currency, but take time to accumulated we don't know the trade balances except monthly.

The US has benefited greatly from issuing its debt in the widely accepted "Reserve Currency": our own dollar. That meant that the US Trade Deficit became dollars in foreign companies hands (Toyota) who exchanged their dollars for Yen at the Japan Central Bank (BOJ), who then bought Treasuries that became reserves of the money issued by the BOJ. That funded the US government debt, so our trade deficit was absorbed by capital flows to the US. Ditto China, and each country gave us a $1+ trillion to fund federal budget deficits, under the questionable assumption that the dollar is the world's safest currency. As a response to the Russian invasion of Ukraine the US "froze” some $300B of Russian foreign currency. Felix Zulauf calls that the worst blunder the US has made in decades, because countries who feel that they may be on bad terms with the US don't want to risk the ire of the US in commandeering their assets. Foreigners who were big holders are now selling off holdings.

All year, the dollar has been rising, on the dollar milkshake theory that suggests the higher faster rate hikes by the Fed offer better return than the Euro and other currencies, like the yen. In the last month, the Dollar Index (DXY) has fallen, as the ECB has announced higher rates, the British got into a crisis of fears of too much government spending, requiring them to bail out their leveraged retirement funds, and Japan raised JGB rate twice to only .5% but also to defend the declining yen. DXY has dropped to 104 from 114.

The big problem in most countries is that Central Banks have figured out that they and their governments and bankers benefit from printing up new money. The US just passed an Omnibus spending bill with sizable increases in military and social programs of about 8% The inflection for the US is that the funding of these deficits requires some sector to buy the US Treasuries to fund the deficit. The Congressional Budget Office produced long term estimates of continuing deficits of over a trillion a year indicating that the US debt will grow from the current $31 T to around $40+ in the next 10 years.

Below is a new chart to show that the outstanding Federal Government debt will grow to $60T. Looking at it on a log scale, a straight line reflects a constant growth rate. You can see that the $60T is below the historical growth as projected. So it could be worse than $60T.

The big question for the US government is "Who will buy that new debt?" The CBO 's optimistic projection of only $40 Trillion Federal Debt in a decade is too low. War expanding spending, Recession decreasing tax collection, and new spending on bringing home productive capacity, will make the US Debt closer to $60T, I believe. The chart below shows the main categories of holders of our debt. Banks and domestic investment is the only non-Fed holder that might absorb more debt. Agencies and Trusts were collected as extra taxes to fund Social Security and Medicare for the retirement of the baby boomers. That money was invested in Treasuries and will be spent down in a decade. Foreigners (red) were big holders as described above, but are selling off now. The Fed (blue) was a small participant until the 2008 Financial Crisis when they invented QE, and now are the big provider of liquidity. The job of supporting the government deficits is left to the Fed.

The way the Fed funds its purchases is to invent money (Reserves on deposit at the Fed) out of thin air. In essence they "print it". It is just digits in a computer. If the Fed expands it's balance sheet to $40 Trillion, then what might the inflation become over the decade? I suggest that the future will see double digit inflation. Don't hold any currency for a long term. After the coming recession, and then the big Fed pivot, buy assets like gold, oil, real estate and probably stocks.

Stefan Jovanovich comments:

The question should be who is going to sell. Even now, the volume of "new" debt remains a fraction of the amount already outstanding. This is a graph of the ratio of the Federal deficit/surplus to the outstanding Federal debt.

Gary Phillips comments;

monetary policy in the u.s. drives the euro more than the ecb does. U.S. exported inflation to Europe because of the strong $. russia gave it an extra putsch. lagarde will do too little, too late. fed is rolling off $95BN per month from it's balance sheet, and prices of durables et al are deflating. yet, treasuries and corporates aren't buying the hype, and japan and china aren't buying our debt. unsinkable M2 keeps falling = less $. powell will do too much, too late, so can't see how the flow doesn't go to the greenback.

Stefan Jovanovich points out:

$ vs Rupee

John Floyd responds:

While picking the Rupee is a bit of an over simplification it does highlight a broader challenge. we have had 20 plus years of easy credit and capital inflows (from China) by and large the opportunity to solidify balance sheets, infrastructure, etc., was squandered. that is particularly true for large swaths of EM countries. this will not be a straight line though and there is growing probabilities of Russia resolution, inflation lower at least short to medium term, and China is opening up with added stimulus. so that rewinds much of 2022. my sense is if that occurs it will help Euro at least short term. doesn’t change the longer-term issue of debt explosion and unclear resolution to such. Madame L is well aware of the challenges and has been since her time at IMF…but politics, survivorship, democracy on ECB, etc., all at play.

Nils Poertner asks:

good questions to ask (not just for fx): where do we think are any current consensus views wrong? what is consensus in the first place? and what could be possible trigger for change? and then, with what product does one want to express view?

Paolo Pezzutti writes:

The ever increasing debt both in the US and Europe in the medium-long term may stimulate the choice/search of alternative assets to fiat currencies and bonds. Financial crisis may start any time triggered by a butterfly somewhere around the globe. The "system" has increasing vulnerabilities because of sustainability of debt. In Europe particularly this may challenge the Euro in many ways. Besides gold, the role of crypto in this regard may provide options. Central bank digital currency on one hand. Bitcoin, etherium and alt coins have lost much of their value under frauds, regulation issues, etc. However, they remain a "challenge" to the incumbent system. How relevant will crypto become and its implications?

Stefan Jovanovich writes:

Our algorithm, which assumes that all investments will be in U.S. $ securities, says the bet now is 60/40 but the 40 is to be invested in common stocks that pay dividends, not debt. This is, as LW says, the beginning of a new market; but "Late to the Party" has been our motto for several decades now, and we see no reason not to follow it. As of year-end, 98.5% of the AUM is in Treasury notes with a weighted average maturity of 8 months. We expect to start investing the funds from the maturing Treasuries beginning at the end of May. This comment and 10 Euros may buy you a decent cup of coffee in Basle.

Larry Williams offers:

May not be a great year for gold:

Alex Forshaw wonders:

LW is now Uber bearish?

Larry Williams responds:

No have no position that is just an observation on gold.

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