Prior to the creation of the euro, FX markets were a market maker’s paradise. The many European currencies provided a myriad of combinations to hedge and trade. There was always someone willing to pay a fair spread for some late-night liquidity in the guilder/peseta cross rate. After the euro was adopted, some traders found themselves without gainful employment. A few retired happily, while others reinvented themselves as strategists, electronic market makers, and baristas. 1 1 Close And maybe weekly commentary writers. Their fixed income colleagues fared only a little better. Most investors thought all of the countries that used the common currency were of similar credit, so the bonds traded with tight, reasonably stable spreads. The euro crisis shattered that illusion and battered bondholders. It also briefly brought back some of the forgotten FX traders from their coffee stations. At the peak of the European crisis, investors feared the euro would break up into multiple currencies, some of which might be worth less than others. Italian and Spanish bonds required extra yield to compensate holders for this risk. They traded more like currencies than bonds. 2 2 Close It wasn’t clear what would happen if the euro broke up. European sovereign bonds may have remained in some sort of proxy euro, which would have made it very difficult for countries returning to their old currencies to pay.
Mario Draghi ended that episode with his famous “whatever it takes” speech, 3 3 Close European Central Bank: “Speech by Mario Draghi, President of the European Central Bank at the Global Investment Conference in London,” 7/26/12. but it may be helpful to remember those lost foreign exchange traders when thinking about last weekend’s European Parliamentary elections. The elections drew more interest and participation than any of the pan-European contests in recent memory and rekindled some of the concerns from the crisis. Many voters view the European elections as symbolic because the Parliament doesn’t directly govern the individual countries. It’s not clear they have any idea what the Parliament actually does. 4 4 Close It’s not clear the members of the European Parliament know either. Some candidates portrayed the election as more about attitudes toward the European Union than any specific policy proposals.
The results were very much like the EU itself: a mix of a lot of different parties with no clear leader or winner. 5 5 Close For results of the European Parliamentary elections, see: Financial Times: “European elections 2019: Live results,” 5/29/19. The biggest shift was that traditional parties such as Christian Democrats and Social Democrats lost seats, while a variety of other parties gained. 6 6 Close There were exceptions, such as Spain, where the Socialists and Democrats gained seats. Pretty much any general statement made about these elections will have exceptions. Euroskeptic parties did well, particularly in Italy and a few other countries, but maybe not as well across Europe as some had predicted. 7 7 Close Italian bond yields have risen over the past few weeks, but that may have more to do with the fact that the EU is considering fining Italy for missing its deficit target. Smaller pro-European and Green parties also gained. In the U.K., the Brexit party had a very strong showing and won the most seats, but the Liberal Democratic party, which had been left for dead just a few years ago, ran on a remain platform and was among the biggest gainers in Europe. It looks like the new European Parliament is more fractured, but more than two-thirds of the seats are still held by pro-European parties.
It remains to be seen which coalitions will form, but it will be difficult for any side to get meaningful reform passed in such an environment. Despite all of the dissatisfaction expressed by the electorate, the results paradoxically reinforce the status quo by creating additional gridlock. It doesn’t seem as though the euro faces any immediate break-up threats, so the former FX traders will have to keep serving lattes. There may yet be some reform, but European leaders such as Macron and Merkel are focused on filling the big positions first. The most important is the President of the European Commission, which is currently held by the Luxembourgish politician Jean-Claude Juncker. 8 8 Close I didn’t know that Luxembourgish was a correct adjectival demonym. Luxembourgian is also used. The leading candidate was thought to be the German Manfred Weber, but Macron has been promoting his countryman and top EU Brexit negotiator, Michel Barnier. 9 9 Close Macron hasn’t been blinded by the light. From the perspective of markets, the European Commission Presidency probably doesn’t matter all that much in itself. Outside of maybe one or two days of the crisis, investors haven’t spent much time parsing Juncker’s speeches for hidden meanings.
Only European Central Bank (ECB) President Mario Draghi gets that kind of a following, and his term ends later this year. Since its inception, the ECB has had presidents from the Netherlands, France and Draghi’s Italy. The EU respects geographic diversity so it is less likely that the next ECB President will be from one of those countries. The list of potential candidates is too long to show here, but according to reports, the two front runners are former Bank of Finland Governor Errki Liikanen and Germany’s Jens Weidmann. 10 10 Close France’s Benoit Coeure and Francois Villeroy de Galhau are also potential candidates. Wall Street Journal: “In Europe, Haggling Begins Over Who Will Succeed Mario Draghi,” 5/27/19. Current Bank of Finland Governor Olli Rehn is also in the running, possibly because people feel strongly that the next governor should be Finnish. Casual investors are probably comfortable with Rehn and Liikanen because they don’t know much about them. Those who follow the ECB more closely know that both Liikanen and Rehn have been fairly dovish ECB members who have supported Draghi. Weidmann is more of a hawk. He was critical of the ECB’s actions on quantitative easing (QE), and has pushed for normalization of rates. Lately, however, he hasn’t seemed like he’s in a rush to hike rates, preferring to give vague pronouncements like “an extremely accommodative monetary policy stance cannot be allowed to go on forever” rather than pounding the table. 11 11 Close BIS: “Jens Weidmann: Monetary and economic policy challenges,” 5/7/19. He may be holding back to strengthen his candidacy, but it may be out of his control. It is unlikely that Germany will get to lead both Parliament and the ECB, so the ECB choice will depend on who wins the European Commission Presidency. Weidmann may have to root for Barnier.
If Weidmann is selected, it could spark an initial reaction from markets, but monetary policy might not change much in the medium term. He would be somewhat constrained by the other members – the ECB President is not all powerful – and he has shown some willingness to compromise. Unless European data improves, there will be little support for policy normalization regardless of who is in charge. We might see real differences between a Weidmann ECB and a Draghi ECB if things start to deteriorate. It is hard to imagine Weidmann acting as aggressively as Draghi did or giving blanket policy guarantees. The Bundesbank, which Weidmann currently leads, has always been strongly opposed to a German or pan-European assumption of individual countries’ debt, whether it is explicit or implicit. In the meantime, Italy is testing the EU on its commitment to enforcing deficit rules, with some of its leaders emboldened by the results of the election. This makes it more likely that former FX traders will get their jobs back at some point in the future, but for now, they can continue to write “Dr. Jens” on Weidmann’s coffee cup.
What We Are Watching
U.S. ISM Manufacturing PMI (Monday)
While U.S. GDP growth was quite strong in the first quarter, a number of more recent data releases suggest that the economy may now be slowing down. April data on industrial production and durable goods orders fell short of economist forecasts, and the ISM Manufacturing PMI fell to its lowest level since 2016, providing additional evidence of a downshift in growth. 12 12 Close Bloomberg, Federal Reserve, U.S. Census Bureau, Institute for Supply Management. All data for the month of April 2019. Weakness in official data and high-profile surveys such as the ISM suggests that slower global growth and escalating trade tensions may be weighing on U.S. industrial activity. Another weak PMI reading in May could cause economists and market participants to revise down their expectations for U.S. growth, potentially weighing on equity prices and boosting Treasuries.
Australia Central Bank Meeting (Tuesday)
Over the past few months, the Reserve Bank of Australia has had to weigh a weakening inflation backdrop against a strong labor market. Until its last meeting, the central bank had decided to prioritize labor market data and keep rates unchanged. However, recent comments by Governor Lowe suggest that the bank is reassessing its interpretation of labor market conditions. Should the RBA conclude that there is still significant slack in the labor market, it would resolve the current tension between employment and inflation data, opening the door to looser monetary policy. Economists and market participants are attaching high odds to a rate cut at next week’s meeting. Indeed, markets are now fully pricing additional easing in the remainder of the year. As a result, if the RBA cuts rates but appears non-committal on the outlook for further cuts, it could prompt weakness in Australian fixed income and strength in the Australian dollar.
U.S. Employment Report (Friday)
The labor market has remained robust in the U.S. in recent months. April data came in better than expected, with the unemployment rate reaching a 49-year low at 3.6%. 13 13 Close Bureau of Labor Statistics However, wage data for April was weaker than expected and is likely to be a key area of focus in the May data release. Similar to other developed countries, the tight U.S. labor market has thus far led to only modest wage increases. Given ongoing trade concerns, the composition of jobs added in May will also be watched to see if trade-sensitive industries are coming under pressure. Further, the labor force participation rate will also be analyzed, as participation has, on the margin, declined recently. While jobless claims and other higher frequency employment data are not showing signs of weakness, if the data surprises to the downside, it could add support to market pricing of Fed rate cuts. An upside surprise to the jobs data or wages would likely be bearish for U.S. fixed income and could allow the Fed to hold firm on its more neutral stance.