Traditional patterns no longer work. Relationships and models traditionally used in currency valuation have broken down over the past two years, explaining why the market consensus has been consistently wrong on the euro. While the forecasting community and investors expected the euro to rally from its introduction, it failed to meet expectations. In fact, the euro has lost more than 30% since its introduction and although its has been trending down, the forecast community has remained bullish, obviously relaying on models which no longer work.
Past relationships suggest that currency movements had been driven by relative yield and interest rate differentials. However, this relationship no longer exists and we attribute this change to the fact that the relative size of government bond markets has declined. Facing demographic challenges, most Western governments have started to consolidate public budgets aiming to reduce outstanding debt. While the reduction of public debt is structurally positive, it does reduce liquidity in government bond markets, leaving them less attractive to foreign investors. As investors start to concentrate on investment alternatives in corporate bond and equity markets, the government bond yield differential has lost its forecasting ability.
Meanwhile, the importance for currency analysis of equity and corporate bond markets has increased. We attribute this development to two factors. Firstly, the declining attractiveness of government bond markets, and secondly, the fact that an increasing amount of private and corporate savings are being put under professional fund management. Professional fund managers examine a broader spectrum of investment alternatives and are free from national preferences. Private investors keep their financial investments within national borders.
In Anglo-Saxon countries, funds under professional management have sharply increased, especially between 1985 and 1995, running parallel to the significant pension reforms. In consequence, total funds under management in the US comprise $18trn, while funds under management in Euroland are a mere $6.125trn, although Euroland has a higher population than the US. The reason for the discrepancy is related to the fact that US, like other Anglo Saxon countries, have been moving to capital based pension funds in order to face the challenges of an ageing population. In Euroland this problem has not yet been tackled, but with the existing pay as you go pension system unable to cope with the demographic pressure being put on the system, European governments have started to reform.
However, these reforms come late and the population has become sensitive to the pension issue. Private investors have started to shift savings into life insurance and pension funds, leading to an exponential growth of this business. Moreover, the German government has agreed to sanction contributions to capital based pension funds via tax incentives, emulating the Dutch pension model.
Accordingly, we assume that Europe has entered a period of financial capital accumulation. The vast majority of this capital will be under professional management, implying a professional asset allocation accompanied by a related currency allocation. Even conservative fund managers would consider a 20% allocation into foreign currency assets as appropriate. Taking the numbers from the Netherlands as a guide, we assume that Europe will face pension reform related currency outflows of about $2trn within the next 10 years, suggesting an average portfolio related outflow of $200bn each year. However, this is just what was seen in Anglo-Saxon countries from 1985 to 1995, which helps to explain why Anglo-Saxon currencies were weak during this period.
On the FDI side, flows are likely to remain euro negative at least for a couple of years. Europe has a slower growth potential than the US as impressively illustrated by the growing divergence of structural unemployment, but with European governments sitting on their hands ahead of general elections in France and in Germany next year, the growth potential divergence is likely to remain in place. However, growth divergence provides a guide to investment return expectations and from this side FDI flows are likely to remain a euro negative factor for the time being.
Hans Redeker is chief currency strategist of BNP Paribas Group in Paris

Topics