1. Fed update
As expected, the Fed cut its policy rate by 25bps to 2-2.25% for the first time in 11 years despite an unemployment rate standing at an all-time low and equity valuations sitting at all-time highs. We mentioned in our previous articles that a "large" cut (i.e. 50bps) could have sent the market a wrong signal and therefore generating a sudden rise in price volatility. The last time the Fed cut rates by half a percentage point was in September 2007 as concerns over the mortgage meltdown was haunting Wall Street and Main Street and fears over a recession were rising significantly. As Powell mentioned it in his May speech on financial stability and business debt, we currently stand in the middle of the range from "This is a return of the subprime crisis" to "nothing to worry about here". Even though the rise in lending to risky borrowers through the use of securitization vehicles makes us feel similarities with the subprime mortgage crisis, there are still notable differences.
The Fed chairman confused the market once again by contradicting himself during the press conference by saying on one hand "This isn't the start of a long series of rate cuts," and on the other hand, "I didn't say it's just one rate cut". As we mentioned in our previous article, despite leading indicators showing that inflationary pressures remain firm for the next 12 to 24 months (NFIB surveys or Underlying Inflation Gauge pricing in higher core inflation), the rise in uncertainty combined with the dynamics of the short-end of the curve, with the Fed Funds' effective rate trading above the Interest on Excess Reserves, has weighed more on US policymakers' decision.
The US dollar remains the preferred currency for the time being and continues its momentum against all the developed currencies. Figure 1 shows the USD index; it is now trading slightly below the 99 level, and our Elliott Wave analysis shows that we could see further upside to 100.2, which corresponds to the 76.4% Fibo retracement of the 88.2-103.9 range.
2. Outlook for the Euro
The little improvement we saw in economic data in the Euro area has raised hope to some market participants that the business activity may start to pick up in the coming quarters. Figure 2 (left frame) shows that the Economic surprise index rose significantly in the beginning of the year (from -88 to 0) until recently; however, our key forward-looking indicators are still showing signs of anxiety and potential further weakness in the coming quarters. First, manufacturing PMIs in the four biggest economies are now all below the 50-line threshold, which separates growth from contraction. With a manufacturing PMI at 43.2, Germany is suffering from the slowdown in global trade. The Bundesbank is expecting growth to slow down significantly this year, the slowest rate in six years, as uncertainty remains elevated.
Source: Eikon Reuters
As a consequence, the German 2Y10Y yield curve has continued to decrease and currently trades at 33bps, its lowest level since August 2008. Despite this long period of interest rate that has questioned the sustainability of the yield curve to predict recessions, we still use it as one of our key inputs of our leading economic indicator, using a six-month lead (figure 3, left frame).
Our second leading indicator is the year-on-year growth of German factory orders that has continued to plummet since the beginning of the year. Manufacturing matters in Germany as its share of GDP is ranging from 20 to 25 percent, two times more than the share of the US, UK or France. Figure 3 (right frame) shows that the YoY growth factory orders tend to lead Euro industrial production by three months.
Source: Eikon Reuters
The following charts show two important indicators of economic sentiment that we like to watch: the ZEW and IFO surveys. The ZEW index, for instance, covers a number of areas, sectors and regions and aggregate sentiments of roughly 350 economists on the futures outlook of Germany and the Euro area. Figure 4 shows that both indicators are trending lower and are showing further weakness in the industrial production coming ahead. The IFO survey currently stands at its lowest level since November 2009 (lower than in 2012).
Source: Eikon Reuters
Eventually, we also like to look at the dynamics of smaller countries such as Sweden or Switzerland as fundamentals tend to also lead the European ones over time. We saw that Swedish manufacturing and services PMIs have been crashing in the past six months, also leading Euro industrial production by six months (figure 5, left frame). In addition, the sharp fall in Swiss manufacturing PMI has also been pricing in a deceleration of the economic activity in the Euro area, which has been strengthened by the Swiss franc against the euro. EURCHF is now trading below 1.10, and it looks like it is going back to parity within the next three to six months if Europe continues to weaken and pressure the SNB to act.
Source: Eikon Reuters
It looks like the euro is vulnerable in the short run, especially against the US dollar, the Japanese yen and the Swiss franc. First, the fact that the single currency did not react to the Fed's pivot earlier this year, with Powell switching from "long way from neutral" in his October speech to "appropriate stance" in the end of January, has led us to be sceptical about a recovery in the euro. Second, the non-reaction to the drastic fall in Italian yields confirms that the single currency remains vulnerable in the short run. Figure 6 (left frame) shows that the rise in the 10Y Italian yield that occurred in April /May 2018 was one of the key drivers of the EURUSD exchange rate.
We do not think that the Fed's cut will matter in the short run as investors will favour the US dollar as uncertainty remains elevated. Figure 6 (right frame) shows that the real interest rate differential between the US and the G3 economies (Euro, Japan and UK) has been one of the major drivers of the US dollar in the past cycle; however, we could see a little divergence in the short run with the dollar making new highs.
Source: Eikon Reuters, RR Calculations
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in EURUSD over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.