It may seem counterintuitive at first, but the concept of investment returns is at the heart of currency valuation. After all, if one jurisdiction has an excess of attractive investment opportunities and another jurisdiction has none, quite naturally funds will seek out the better deal. Those capital flows drive currency appreciation in their new found home. Purchasing those investments directly appreciates the currency, while the influx of investment spurs growth and ultimately leads to tighter monetary policy. It’s not a revolutionary idea, but if we know where value is found, we also have an intuitive understanding of which currency will appreciate and which will depreciate. In the current landscape, it also poses a curious question: What if there are no attractive investment opportunities because asset prices have been blown out by years of central bank purchases?
Over the past several weeks, US Treasury yields have collapsed. Even far-dated US government bonds—which do offer a reasonable return—are nauseatingly sensitive to changes in interest rates and are a poor alternative. Corporate bonds provide no answer either when yields are near historic lows. Hedge funds, whose hardships have increasingly adorned newspaper covers, still offer good returns but will investors ever be able to cash out of that investment?
The latest central bank shift to a supportive monetary policy is not a blessing, it is a curse. Bloated asset prices will remain corpulent for that much longer when interest rates decline to support the buying addiction. So, what is the answer to this seemingly intractable problem? We modestly suggest that fiscal policy will finally have to come to the party, because the central bankers are holding a nearly-empty punch bowl.
Bottom line: Be wary of the current Euro rally underpinned by equity appreciation. If the music stops, the countries with the capacity for supportive policy—fiscal and monetary—will have a seat, and the Euro Area is on the wrong side of all of those metrics.
Prime Minister contender Boris Johnson kept a no-deal Brexit on the table last week, causing Sterling to slip back below 1.27. The UK economic calendar is light this week with Purchasing Managers’ Index (PMI) figures taking the front seat, although the political leadership contest will likely drive volatility.
Geopolitical tensions will continue to be a key driver of the Greenback this week along with PMI’s and Non-Farm Payroll data. Strong readings will ease pressure off the Federal Reserve to cut interest rates – a policy move that is already largely priced in.
The Euro continues to trade at the top of its trading range as the European Central Bank (ECB) weighs up different tools at its disposal to provide much-anticipated liquidity stimulus.