Draghi? Draghi. Draghi!
David R. Kotok
January 3, 2015
A German newspaper reports Mario Draghi’s denial of interest in Italian politics as a major story, which then makes its way to the financial news in the US. Really?
First, it is appropriate for the president of the European Central Bank to say that he wants to avoid politics in his home country of Italy. Anything else would be inappropriate. Next, he chose a German newspaper, Handelsblatt, as the conduit by which to reinforce the message that he is facilitating the introduction of huge additional monetary stimulus, which the Germans have opposed. Draghi is really telling them, “I’m going to be here.”
With the expansion of the Eurozone to include Lithuania and with the new composition of the Governing Council, the odds of additional stimulus in the Eurozone have improved immensely. On top of that, deflation risk is rising in Europe. The economies of Europe are on a very flat growth path. They have high unemployment, large structural impediments, no apparent inflation, and either extraordinarily low growth or actual shrinkage, depending on which country we examine. The tool of European fiscal policy is hampered by huge deficits and lots of unfunded social liabilities.
Monetary expansion is the only game in town. Interest rates have already fallen to levels below zero in some shorter-term instruments and near zero in others.
We expect a large monetary stimulus to originate from the European Central Bank as early as the end of this month. Markets are building this expectation, which will mean a huge market disappointment if the ECB does nothing.
But what if the ECB actually takes a larger quantitative easing (QE) action? Where does the euro go versus the dollar and other currencies? There are lots of estimates floating around, but we think it is important to reflect on history. Let’s take a look.
The Maastricht treaty took years to negotiate. When the first exchange rate setting was implemented in 1998, and the initial 11 countries formed the Eurozone, the estimated US dollar value of the newly launched euro was $1.32.
The virtual euro was introduced in 1999. Paper currency came three years later. During the introduction of the virtual euro, the range went from the pre-virtual $1.32 at Maastricht rate-setting time to $1.17 at the opening of trading. During the virtual period the euro hit a low of $0.83. Yes, the euro lost one-third of its initial value during its rollout as a virtual currency.
Subsequently the paper currency replaced the franc, peso, D-mark, and others. The new euro was quickly and fully accepted. Ultimately the success of the euro and the optimism behind it brought it to a level above $1.50. That’s right, the $1.32 treaty price estimate became a virtual euro at $1.17 that fell to $0.83 and then recovered to a full-fledged euro that rose above $1.50.
So we observe that the 16-year volatility range of the dollar-euro exchange rate has run from about an $0.80 low to a $1.50+ high. Today we are at about $1.20.
Now we are about to see the widest policy disparity to date between the US central bank (the Fed) and the ECB. These are the world’s two largest central banks. Together, they influence the pricing of between 80% and 90% percent of all world reserves.
They are about to go in opposite policy directions. The Fed has moved from quantitative easing to neutral. It is setting up to raise interest rates in 2015 and to start the process of exiting itself from years of QE. There is now a vast policy chasm between the Fed and the European Central Bank, which is at zero interest rates and looking for ways to embark on additional QE in order to take its balance sheet size above €3 trillion.
In the US we have an expected growth rate for 2015 of about 3.5%. Our economy is doing better. Our inflation rate is low. And we will move away from the distortions of zero interest rates by the end of 2015. In Europe, the picture is the inverse of what we see in the United States.
The result is that the dollar could be surprisingly strong during the course of 2015. It has emerged and validated its worldwide reserve currency status. And its strength is further validated by the activity in Japan.
At Cumberland, our strategies are designed to capture the benefits of a strong dollar as well as the benefits that may flow through from weakening currencies like the euro and yen. The disparities in policy between the Fed on the one hand and the ECB and the Bank of Japan on the other mean that volatility will increase substantially and with results quite different from those we have seen in the past seven years.
Investors will learn that volatility is bidirectional. Add currency exchange rates to asset prices, and the situation gets very interesting. The path is geometric, not linear.
It’s 2015. The horses have broken from the starting gate. Mario Draghi is now the lead jockey, the track favorite – but will his horse fade in the stretch? And is Mark Carney’s British pound a dark-horse long shot?
David R. Kotok, Chairman and Chief Investment Officer