It’s 2007 all over again.
The euro is on a tear, U.S. investors are snapping up European stocks — and traditional theories to justify the shared currency’s spirited advance have broken down, as investors luxuriate in a climate of low volatility.
That’s the market landscape as painted by Deutsche Bank AG strategist George Saravelos. Given the parallels, he suggests caution after the euro’s 7 percent rally against the dollar this year.
“Something strange has happened to the euro in recent months,” Saravelos wrote in a client note Wednesday. “Almost all traditional drivers that usually ‘explain’ the price action have broken down.”
The bank’s currency correlation model — which includes factors such as interest-rate differentials, the relative performance of equity markets, and spreads of southern European government bonds — is flashing red.
Correlations between the euro’s rolling three-month performance against the dollar and other such factors were last at current subdued levels in early 2014 and 2007.
That suggests unhedged equity inflows from foreign investors piling into European equity and bond markets — thanks to better-than-expected economic data, and easing political risk — have driven the currency’s recent outperformance, according to Deutsche Bank.
“Near-term, it suggests that there may be an underlying flow story that is impervious to other market drivers and is supportive of the euro,” Saravelos said. “Medium-term, the current ‘decorrelation’ is usually associated with periods of very low volatility and would suggest caution in extrapolating recent euro strength.”
As such, the German bank, the world’s fifth-largest currency trader by market share according to a Euromoney Institutional Investor Plc, reckons the euro will fail to break out against the top end of its 1.05 to 1.15 per dollar range, as traditional currency drivers re-assert their influence.
Risks to the currency’s bull run are rising: The euro fell 0.2 percent Wednesday after a Bloomberg report on a potential switch in the European Central Bank’s inflation outlook signaled a dovish outcome in a policy decision due Thursday. The euro was flat at $1.1260 ahead of the ECB meeting.
Linking currency moves to capital flows isn’t straightforward when markets move in lockstep, but an April study by Deutsche Bank suggests currency traders should follow flow data closely: It concluded that outsize inflows into exchange-traded equity funds can predict moves in a number of liquid currencies, including the euro.
Saravelos’s note of caution also finds support from Jens Nordvig, founder of Exante Data, a New York-based research firm.
“Fundamental models for EURUSD, based on rate differentials, would have predicted a relatively stable exchange rate in recent months,” Nordvig, who was ranked No. 1 strategist by Institutional Investor for five years through 2015, in his previous capacity as head of currency research at Nomura Holdings Inc., wrote in a client note. “In our analysis, this ‘euro residual’ is tied to certain flow forces, which have turned euro bullish lately.”
We do not see the EUR powering much higher and expect it to reverse course towards the lower end of its 1.05 1.15 trading band soon.
We expect a much more conservative FED decision and volatility to come back to equity markets.
The Japanese Yen rally is also showing signs of exhaustion and we expect it to fall back towards 115 relatively soon.
Another significant event of the week was U.K. Prime Minister Theresa May’s election gamble failing disastrously. The consequences are dire for her party and government, and could be equally bad for her country’s relationship with Europe.
May had hoped to increase her Conservative majority in Parliament, and instead has seen it wiped out. The Tories are the largest party in the House of Commons and with the support of Northern Ireland’s Democratic Unionists intend to form a government. Directing policy and passing legislation, however, will be vastly harder than before.
This would be a serious problem under any circumstances, as Britain’s previous experience with hung Parliaments suggests.
But these aren’t just any circumstances. Brexit talks were due to start in 10 days. May’s effort to prepare for that challenge has left her plans, such as they were, in shreds. The immediate prospect is great political disorder and maximum economic uncertainty.
Such is the humiliation of this setback that May might soon choose — or be forced — to resign. This offers no relief. The task of finding a new leader would only add to the chaos, and there’s no obvious successor capable of uniting the party. But if she hangs on, the question of if and when she goes will linger. Her authority is irretrievably diminished.
It’s possible, in some alternative universe, to see a way forward. With power in the Commons more evenly divided, the need for cross-party consensus increases.
On the biggest and most urgent issue, Brexit, cooperation between the Tories and the Labour opposition shouldn’t be unthinkable: Both parties agree that Brexit should go forward, and neither wants to revisit the decision. There’d be some hope of uniting the country around the goal of a friendlier separation from Europe.
Unfortunately, the Labour Party of 2017 is not the centrist party built by Tony Blair in the 1990s. It is a hard-left party whose organizing principle is militant opposition to Tory rule — and the antipathy is mutual. At the moment, the willing cooperation vital to rescuing Britain from this impasse is all but impossible to imagine.
It will take some time for Britain to absorb the implications of this extraordinary, and in many ways bewildering, election. Another vote, perish the thought, may be the only way to dispel the descending paralysis.
The pound headed for the biggest drop in a year after it emerged that the ruling Conservative Party has fallen short of an overall majority.
The currency slumped against all of its major peers, still, it avoided dropping below $1.24, which the median estimate of analysts surveyed by Bloomberg had predicted under such a scenario. U.K. stocks rose for the first time in five days, while government bonds fell for a third day.
The result means there will be a period of uncertainty while the country, the European Union and investors await who will be at the helm during two years of EU exit negotiations.
Should the Conservatives fail to form a workable government, it will be up to opposition Labour leader Jeremy Corbyn to try and form a pact with the pro-European Liberal Democrats and Scottish National Party, a potentially unstable alliance but one that could also boost market hopes of a softer Brexit.
“Investors will await more clarity on who will be running the country and who will be in charge of the Brexit negotiations,” said Valentin Marinov, head of Group -of-10 foreign-exchange strategy at Credit Agricole’s corporate and investment banking unit in London. “We still see scope for a GBP/USD move toward 1.25 and EUR/GBP toward 0.90,” adding that the bank would be reviewing its near-term forecasts.
The pound has borne the brunt of the U.K.’s decision to leave the European Union, having lost about 15 percent of its value against the dollar since the June 2016 vote. Fewer than five seats are yet to be announced.
The pound slumped 2 percent to $1.2702 as of 8:45 a.m. London time on Friday, after touching $1.2636, the lowest level since April 18, the day May called the snap election. It slid as much as 2.5 percent, set for the biggest drop since the days after the Brexit vote. The decline in sterling has already taken it below analysts’ median forecast of $1.28 by year-end. Against the euro, the pound tumbled as much as 2.3 percent to 0.8860, its weakest level since November.
Despite the hung parliament outcome, sterling did not fall as low as some expected. A Bloomberg survey of 11 banks and brokerages conducted before the exit poll showed that sterling could plunge to as low as $1.20 on Friday while the median forecast for a level of $1.2350. That could either be because investors are awaiting who will form a government, or on the promise that Conservative Party weakness could result in a softer Brexit.
The FTSE 100 index of shares advanced 0.9 percent, the most in Europe. The gauge gets more than two-thirds of its sales from abroad, so the weaker pound typically bolsters the measure. British American Tobacco Plc and GlaxoSmithKline Plc were among the biggest gainers, while companies with a larger exposure to the U.K. dropped.
The pound’s weakness is “an uncertainty discount, rather than pricing the fundamentals of a potential leftist shift in the U.K. government, with a softer Brexit stance,” said Peter Chatwell, head of rates strategy at Mizuho International Plc in London.