On July 15, the euro-dollar exchange rate closed at 1.0085, down 11.3% from the beginning of the year, approaching parity. From July 12 to 14, the euro exchange rate fell below 1 for three consecutive days, the lowest since the end of 2002. The U.S. dollar index rose steadily, crushing the euro, the pound and the yen, and rose 12.9% from the beginning of the year to July 15, hitting a 20-year high. During the same period, the appreciation of the US dollar against the euro contributed 56% of the rise in the US index.
The interest rate differential, which measures the attractiveness of asset prices between countries, has an important impact on the exchange rate trend, but there are two “paradoxes” in the important interest rates in the United States and Europe. The first is that the narrowing of the US-German 10-year bond yield gap has not saved the euro from the decline. Since the beginning of this year, the yields of US and European government bonds have risen sharply. The yield of the 10-year US Treasury bond has exceeded 3%, and the yield of the 10-year German bond has also shaken off negative yields. After May, U.S. bonds peaked and fell, and the U.S.-German interest rate spread gradually narrowed. On July 15, it fell 36 basis points from the high point in April, and fell by up to 59 basis points during the period. The second is the inversion of the U.S. bond yield curve and the steepening of the German bond yield curve. Since the spread between the 10-year and 2-year U.S. bond yields peaked and fell back in April, the U.S. bond yield curve has further flattened. It began to invert on July 6, and inverted by 20 basis points on July 15, which is similar to the inversion during past recessions. The range is comparable; the difference between German 10-year and 2-year yields is close to 100 basis points.
On the surface, the US traded recession expectations and European traded stagflation expectations are more in line with their respective economic status quo. The U.S. economy is entering a slowdown stage from an overheated state, with negative real GDP growth in the first quarter, and further weakening of indicators such as PMI, durable goods orders and consumer confidence in the second quarter. Markets speculate that the U.S. economy may even have entered a technical recession. The economic recovery in Europe is not as strong as in the United States. The euro zone has been hit hard by the epidemic, and the physical quantity of the economy has not recovered to the level before the epidemic last year. It is also the main victim of imported inflation, and the Ukraine crisis has significantly increased its stagflation risk.
However, high inflation is a global phenomenon. If a U.S. recession causes global energy prices to fall, Europe could quickly switch from stagflation to recession mode. From this point of view, the German bond yield curve is not a simple stagflation transaction. In fact, it may be that international capital is not optimistic about the prospects of Europe, and the risk aversion to the United States has triggered two “paradoxes” in the bond market.
Looking further, the euro still has three major “stubborn diseases”. The first is the loose fiscal and uneven distribution of debt within the EU. As the government leverage ratio of southern European countries is significantly higher than that of northern European countries, as long as they enter the monetary tightening cycle, the hidden danger of the European debt crisis will appear again. Once the slowdown in economic growth and passive fiscal contraction meet, economic problems may lead to social problems. This leads to the second “stubborn disease”, that European integration lacks the basis of political integration. The EU is more like a union of nations than a federal state like the US. If the people of southern European countries cannot stand high inflation and declining welfare, causing social unrest, it will further hit the euro. Recently, as the “Five Star Movement” party refused to support the Italian government’s bailout plan to help people cope with rising energy and living costs, differences within the ruling coalition were exposed, and Prime Minister Draghi once wanted to resign. The third is that the conflict between Russia and Ukraine is not up to Europe, and Europe is already in a difficult position. Natural gas accounts for 25% of Germany’s total energy consumption, while 55% of Germany’s natural gas comes from Russia. Although the EU advocates saving energy together to alleviate Germany’s urgent needs, the adjustment of the energy structure will not be easy in the short term. In particular, the people of countries that do not have the ability to subsidize can not bear the high price of natural gas and still have to send natural gas to Germany, which further aggravates the second “stubborn disease”. Recently, the natural gas maintenance of Beixi No. 1, the German energy giant was forced to divert the winter gas storage, resulting in a decline in the gas storage level again, and there is great uncertainty in how to survive the winter this year.
The performance of the euro during the year can only be seen on the “face” of the dollar. The euro’s sharp fall failed to prevent Europe from rushing to buy energy around the world, and by May this year, the EU had run a trade deficit for the 10th consecutive month. That month, Germany posted its first seasonally adjusted deficit of 1 billion euros in 30 years. If the EU’s current account deficit continues to worsen, it will further increase the pressure on the euro’s depreciation. Therefore, the “turnover” of the euro is likely to wait for the dollar to turn around.
Curbing inflation is the Fed’s top priority right now. In June, the US CPI exceeded expectations again, with a year-on-year increase of 9.1%. And June’s strong non-farm payrolls and retail sales data gave enough cushion to a tightening-induced recession, making it impossible for the Fed to turn around easily. Fed officials, including Powell, have repeatedly said that it is only possible to see inflation trend back to a reasonable range. Taking into account the base effect and leading indicators of house prices and rents, the US CPI may remain stubborn in the third quarter, and the fourth quarter will become particularly important. The unprecedented aggressive tightening by the Federal Reserve and the European Central Bank’s scrutiny of tightening are judged on a high level.
Risk aversion will also support the dollar. At present, the Fed’s tightening will either crush domestic demand in the United States, or attract the return of US dollars to trigger an overseas debt crisis. The inversion of the U.S. Treasury yield curve has been defined by the market as an artificially created global recession by the Federal Reserve, which guides demand contraction to balance high inflation pressures. Once the U.S. dollar liquidity crisis turns into a financial systemic risk and a rapid economic contraction, risk aversion will explode and release in a concentrated manner, pushing the U.S. dollar to peak and fall. Now that a stronger dollar hasn’t forced the Fed to turn, let the bullets fly for a while.
