In memory of Dr. Andreas Höfert

Three rebounding 2014 overshoots shouldn’t shake the Eurozone

| Posted by: Andreas Höfert | Tags: Follow UBS, Andreas Höfert

Three strong trends characterized 2014: the US dollar strengthened (especially against the euro), oil prices dropped and European yields slid. All three shifts have halted or even reverted in 2015. What’s causing this, and what are the potential consequences?

“There and back again” is the subtitle of J.R.R. Tolkien’s The Hobbit. It also applies nicely to the three trends that started in 2014 and have ended abruptly, or at least experienced a strong setback over the last few weeks.

From its high at 1.39 in May 2014 to a low slightly below 1.05 in March 2015, the euro lost roughly 25% against the US dollar. Trading now around 1.12, it has regained roughly 7%. From its peak at over USD 115/bbl in June 2014 to a low under USD 47/bbl in January 2015, Brent crude oil lost almost 60%. Now it is trading slightly above USD 64/bbl, having regained roughly 38%. From 1.44% in May 2014 to 0.05% in April 2015, the yield on 10-year German government bonds fell by almost 140 basis points, but has since rebounded by 60bps.

In our puzzlement at this erratic behavior we can blame – logically – the irrationality of markets. However, almost 40 years ago, the late Rudiger Dornbusch (see: Rudiger Dornbusch (1976): “Expectations and exchange rate dynamics”, Journal of Political Economy, 84, pp. 1161–1176) professor of economics at MIT, showed that even under perfect foresight, assuming that the real economy is sluggish compared with capital markets, which move instantaneously, exchange rates will tend to overshoot their new equilibrium value if a shock changes the equilibrium. The bottom line is that asset markets move much faster than the real economy and sometimes run very far ahead of themselves.

Looking at exchange rates, it appeared at the beginning of 2014 that the USD would strengthen (which we also forecast). At 1.39, the euro was roughly 15% overvalued against the USD in terms of estimated purchasing power parity. Moreover, the narrative of relative tightness of central banks used to explain the strengths or weaknesses of currencies was altering: Mario Draghi at the European Central Bankwas softening, was pondering quantitative easing (QE), while Janet Yellen and the US tapered QE to an end and began contemplating a first rate hike.

In hindsight, the fall in oil prices now also seems obvious. With more fracking in the US, the oil market became oversupplied, because the usual marginal supplier from OPEC, Saudi Arabia, didn’t play its traditional role of stabilizing prices. However, at USD 50/bbl, fracking investments become uneconomical, so as we forecast a couple of months ago, that growth of oil supply would slow down, leading to a rebound in prices, as we now see.

The least understandable trend was that in European interest rates. I’ve remarked already how it puzzles me to see some Eurozone countries, chief among them Germany, issuing bonds with negative interest rates. Of course the ECB’s announcement of QE played a role in this trend. Nonetheless, given the high indebtedness of all Eurozone governments, I doubt that any investor seriously believed that there would be any shortage of such paper.

The three trends reinforced each other. An across-the-board USD rise usually means lower oil prices as a mirror image. Low yields in the Eurozone compared with the US can trigger carry-trade operations, strengthening the USD further compared with the EUR. Sliding oil prices might increase deflation fears, and accordingly hopes for more QE in the Eurozone, which in turn will push European yields even lower. Of course, now that the trends have reversed, they are also reinforcing each other in the other direction. So it shouldn’t surprise us to see the reversal happening in all three trends at the same time.

A lower euro, lower oil prices and lower interest rates were three good reasons to see the Eurozone today in a much more positive light than a year ago. Does the reversal of these trends imply we need to curb our enthusiasm? I don’t think so. In my view, all three 2014 trends can be seen as impulses having finally initiated a new growth cycle in the Eurozone, which seems sufficiently strong to unfold by itself. Hence, unless the reversal of the trends becomes much more pronounced, and barring a serious accident in Greece, I remain optimistic that 2015 will be the year that the Eurozone will finally reconnect with growth.