Euro fans have a blind spot they keep forgetting

It should have been a good day for the euro after Eurostat said the euro-area economy grew faster in the second quarter than initially reported. But instead, the Bloomberg Euro Index that measures the shared currency against its major peers fell the most in two months, dropping as much as 0.92 percent. The seemingly illogical response by foreign-exchange traders becomes logical when considering what ultimately moves the currency.
Of course, the euro is more susceptible to fallout from the economic troubles in Turkey than any other major currency, so turmoil there could be having an impact. But it’s becoming increasingly clear that the European Central Bank may not be able to bring an end to its currency-debasing quantitative easing measures later this year as planned. That was made clear by remarks by Claudio Borghi, the head of the budget committee in Italy’s lower house.
He told Bloomberg News in an interview that the ECB should keep providing a shield to the government securities of all monetary union members to avoid a breakup of the entire euro system. Borghi’s comments came as speculators drove up Italy’s bond yields on concern the country’s fiscal situation will deteriorate on tax cuts and new benefits spending pledged by the populist government. “Either the ECB guarantee will come or everything will be dismantled,” Borghi said in a reference to the euro system. If it comes down to that, it means the ECB will need to keep flooding the financial system with more euros at the risk of overwhelming demand.
The euro has long been dogged by concern among traders that the shared currency could break up at any moment despite an assurance by ECB President Mario Draghi during the height of the euro crisis six years ago that the central bank would do “whatever it takes” to keep it from breaking apart. That could be true, but coming to the aid of Italy and its $2.24 trillion of debt would be a much harder ask than a Greek bailout. Maybe that’s why the euro’s share of global currency reserves has dropped to 20.4 percent from 24.8 percent at the time of Draghi’s pledge.
Barring some calamity, the bull market in US stocks is one week away from becoming the longest in history. The current rally started on March 9, 2009, with the S&P 500 Index gaining 320 percent, not including dividends. If the S&P 500 is able to make it to August 22 without collapsing, the current bull market will swipe away the top spot from the one that lasted between October 1990 and March 2000 and delivered about a 400 percent return to investors.
Perhaps the most remarkable thing about the current rally is that investors are getting more confident in US equities. A monthly survey of 243 investors with a total $735 billion under management by Bank of America Merrill Lynch found that allocations to US stocks jumped 10 percentage points in August to a net 19 percent overweight, the highest since January 2015. That makes America the most popular equity region for the first time in five years, according to Bloomberg News’s Natasha Doff, citing the firm’s analysts.
A net 67 percent of recipients said the US was the most favourable region for corporate profit expectations, the highest proportion in 17 years. Even so, there’s no shortage of high-profile market mavens suggesting caution. “If there were ever a moment to harvest gains and reduce risk, it is August 2018,” Scott Minerd, the chief investment officer at Guggenheim Partners, wrote in a Twitter posting. “And if it turns out not to be the moment, I don’t think you are giving up much upside.”
The other thing that’s so remarkable about the level of bullishness toward US stocks is the signals being sent by the bond market. After a brief and moderate steepening in late July, the so-called yield curve has started to flatten again. The difference between two- and 10-year Treasury note yields contracted to 26 basis points and is less than two basis points away from the low for the year set on July 17.
The narrower it gets, the more likely the economy is in for a big slowdown — at least going by historical performance. And an inversion, where long-term yields fall below short-term yields, is a reliable predictor of recessions. Some investors and strategists believe that an inversion is inevitable as long as the Federal Reserve keeps raising interest rates. But wouldn’t the turmoil in emerging markets cause the Fed to pause? Not necessarily, according to FTN Financial chief economist Chris Low.
“The Fed’s models do not include international variables,” Low wrote in a note to clients. “As long as they are focused on stabilising the US unemployment rate, they will hike until growth slows significantly, or until the international situation is bad enough to have a significant impact on US markets.” Traders are pricing in 1.6 more Fed rate hikes by year-end, which is little changed over the past three months.

— Bloomberg

Robert Burgess is an editor for Bloomberg Opinion. He is the former global executive editor in charge of financial markets for Bloomberg News. As managing editor, he led the company’s news coverage of credit markets during the global financial crisis