In a new report that may come as music to the ears of Mario Draghi, who has been valiantly hoping to show the European economy recovering while keeping the EURUSD below the “red line” of 1.20, BofA FX strategist Athanasios Vamvakidis is out with a new note today urging currency traders to “stop fighting the central banks”, in other words stop selling the USD and buying the EUR, and recommends shorting the EURUSD to 1.15 with a 1.21 stop loss.
His thesis is simple: markets have been fighting the major central banks, and BofA argues that they will be proven wrong, “leading to lower EUR/USD in the months ahead following the recent rally.” Such a contrary posture by markets is unusual as markets usually follow the simple rule not to fight the G10 central banks, particularly the major ones. However, as Vamvakidis writes, “the market expects very little from the Fed in the rest of this year and next year, despite the unexpected two Fed hikes so far this year and the dot plot having four more hikes by end-2018. The market also seems to expects too much from the ECB-fast QE tapering-despite inflation being well below the target and room for slow QE tapering. The consensus is also that the two central banks will respond differently to low inflation this year, with the Fed staying on hold and the ECB giving up. We disagree and see EUR/USD weakening by the end of this year, following the strong rally so far.“
He lays out the market’s explicit “expectations” as follows:
Markets expect too little from the Fed: The consensus is that the Fed will focus more on low inflation and stay on hold. “We argue that the Fed will focus more on loose financial and monetary conditions, as well as risks to financial stability from asset price bubbles, and will continue normalizing policies gradually. We also argue that US inflation could start surprising to the upside.”
The current dilemma for the Fed in our view is whether to focus on inflation or financial conditions. The two have diverged this year (Chart 1). Despite Fed tightening, financial conditions have been loosening (Chart 2). However, both price inflation and labor costs have dropped (Chart 3) and credit growth has slowed (Chart 4). Overall, US data has been mixed and data surprises have been negative, although less so recently (Chart 5)
The FX strategist then contends that the market seems to be focusing on the low inflation dynamics in the US. Indeed, the market is pricing only a 30% probability for a December hike this year and less than one hike next year. If inflation is so low and has actually fallen this year, what’s the rush? As a result, risk assets have performed strongly, with equities at historic highs and volatility at historic lows.
Here BofA disagrees with this consensus for the following reasons:
And at the same time as expecting too little from the Fed, “markets expect too much from the ECB“
ECB QE has an expiration date. For a number of reasons, the ECB does not seem willing or capable to increase the issue limit or relax the capital key in its QE purchases. QE will have to end next year. However, investors expect a relatively fast pace for QE tapering. Indeed, our Rates and FX Sentiment survey shows that most investors expect ECB QE to be over by mid-2018. Moreover, the market is pricing faster hikes by the ECB than by the Fed for the next three years (Chart 13).
Here the biggest bet by Bank of America is a simple one, and one which Yellen and most of her peers at the Fed recently warned against: the threat, and realization, that the Fed is stoking a bubble:
The key conclusion for BofA is that the market may be underappreciating the concerns of major central banks, and particularly the Fed, for being responsible for the next asset price bubble and a possible crisis after it bursts. Gradual policy normalization can take place despite low inflation under the current conditions.
In FX terms, assuming BofA is right, the FX implications is simple: weaker EURUSD.
The bottom line of the above discussion is a weaker EUR/USD. We believe that given what the market is pricing today for the Fed and the ECB and by how much the Euro has appreciated this year, the risks are asymmetric for a hawkish Fed surprise and a dovish ECB surprise this fall, leading to weaker EUR/USD by the end of the year. We understand that this is a contrarian call, given the EUR/USD performance this year and particularly in recent weeks.
And the recommendation:
We introduce a new trade recommendation to short EUR/USD spot based on our above analysis. Our target for EUR/USD is 1.15, which is also our year-end projection, with stop loss at 1.21, which is above the latest peak. Spot reference is 1.1891. Risks to this trade are the Fed not hiking again this year, the ECB announcing fast QE tapering and the Eurozone economy continuing to decouple from the US.
What are the trade downsides? First, here are the good, bad and ugly scenarios:
Considering alternative scenarios and the implications for the USD:
- In a good scenario, US and global data improves and market euphoria continues. In this case, we would expect the Fed to continue normalizing policies, supporting the USD. Monetary policy divergence and risk-on should support USD/JPY in particular, but EUR/USD could also weaken. The USD could also do well against GBP if Brexit negotiations are slow-as we expect, despite a more pragmatic UK government after the elections this year.
- In a bad scenario, something triggers a sharp sell-off in risk assets. In this case, we would expect the Fed to slow policy normalization, but the ECB would still have to announce QE tapering. EUR/USD would likely appreciate, although not by much, as markets are already pricing a very slow Fed. USD/JPY would suffer the most, but we would expect the USD to still do well against high beta G10 currencies, such as AUD, CAD and NZD, and against EM.
- In an ugly scenario, the sell-off in risk assets is much stronger, risking a global recession/crisis. We would expect in this scenario JPY and CHF, followed by USD and EUR to do well, against everything else. The EUR/USD implications would depend on the specific trigger and the details, and are hard to determine in advance.
Therefore, we believe the USD would do well in most scenarios, although one would have to be selective depending on the scenario. The USD could do particularly well against high beta currencies and EM FX.
All these scenarios also point to higher FX vol. This is easy to argue for the bad and ugly scenarios, starting from a point of low volatility. In the good case scenario, our expectation for higher vol is based on our thesis for Fed monetary policy normalization.
Finally, what is BofA is wrong about central banks?
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