Prophets

Traders Need to Start Giving the Euro and Pound Some Respect

Markets may be discounting the potential for the ECB and BOE to tighten monetary policy.

At a rebate.

Photographer: Lionel Bonaventure

The International Monetary Fund will release its outlook for the global economy on April 10, and the forecasts are likely to reflect expectations for faster growth in 2017 and 2018, even though there are political risks in the European Union from the recent implementation of Article 50 by the U.K. government, as well as from the potential ascension of nationalist parties on the Continent.

Stronger growth is likely to bring more inflation, and central banks do not put their mandates permanently on hold in the face of geopolitical risks. Growth and inflation remain the core missions of central banks and the key drivers of their policies. As such, markets may be discounting the potential for the European Central Bank or the Bank of England to tighten monetary policy. And if they are, that suggests the euro and the pound are undervalued.

One sign of improving future growth and faster inflation is a rise in purchasing manager indexes, or PMIs. Euro-area manufacturing has expanded for 45 consecutive months through March, according to the latest PMI report, released on April 3, suggesting more upside for euro-zone inflation than might be expected. It also helps that manufacturing in the U.S. and China is expanding again at a strong pace after periods of contraction in 2016.

The strength of the economy in Europe is often overlooked because of potential existential risks that threaten the cohesion of the European Union and the European Monetary Union -- the group of countries that use the euro as a currency. But growth engenders inflation, and euro-area inflation has been rising, reaching the ECB's target of 2 percent in February compared with a year earlier. Despite a pullback to 1.5 percent in March, the ECB will need to remain vigilant even if political risks are high.

ECB policy makers have a mandate to contain inflation that outweighs the mandate to support growth, which is grounded in the German historical experience with hyperinflation, more ubiquitous defined-benefits pensions, and Europeans' preferences for investing in bonds. That means it is too bold an assumption to believe that the ECB would be unable to raise rates in the next 12 to 24 months. After all, the ECB hiked rates in the middle of 2008 when it was clear to many that the global economy was slowing. Given the trend of rising euro-area manufacturing, growth and inflation, the risk is that ECB monetary tightening occurs more quickly than foreign-exchange markets reflect. In other words, the euro could be too depressed at current levels. Trading patterns for more than two years now have also shown an inability for the euro to remain below $1.04. And a recent trend of higher lows in place since December 2016 suggests that the euro is more likely to rise than fall.

The British pound could similarly be what traders call oversold. At the March 16 BOE meeting of the Monetary Policy Committee, one governor voted to raise policy rates, but that was enough of a surprise send the pound higher. While Brexit was officially triggered by Article 50 at the end of March, it is likely to take a little more than two years for the full platform to be implemented. Brexit does pose risks to jobs in fintech and financial services -- sectors from which jobs could flee for other locales in the EU -- but solid growth, faster inflation and stronger exports have been engendered by a weaker sterling.

For the BOE, the mandate of inflationary vigilance may not be as strong as the ECB's, but the pound is much weaker, making it easier for U.K. inflation to accelerate. Fed rate hikes are priced in, but tightening is coming to countries other than the U.S., and this is likely to prove supportive of the euro and the pound, even if Brexit or EU political risks are high.

Traders have been all too happy to short the euro and the pound. Germans say Schadenfreude ist die beste Freude: the happiness derived from others’ misery is the best kind of happiness. But if traders have a Schadenfreude trade on against the euro and the pound, they are betting on tail-end events, rather than fundamentals. Euro-area and U.K. manufacturing, GDP growth and consumer inflation are rising. The next meeting of the ECB is April 27, and the BOE's next meeting is May 11. Traders should be watching these meetings closely, especially for verbiage on expected inflation. ECB and BOE rate hikes may be closer than they appear.

Bloomberg Prophets Professionals offering actionable insights on markets, the economy and monetary policy. Contributors may have a stake in the areas they write about.

    To contact the author of this story:
    Jason Schenker at jasonschenker@prestigeeconomics.com

    To contact the editor responsible for this story:
    Robert Burgess at bburgess@bloomberg.net

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