September 14, 2017

The Market Sentimentalist – Are You Experienced?

by Amareos

After all the political surprises and worries about the rise of populism over the past year or so, the upcoming German election slated for September 24, should provide welcome relief. The opinion polls all point to a clear victory by Merkel’s CDU/CSU, with the opposition SPD trailing by some 15 percentage points. We say should, of course, because as we saw with last year’s Brexit and Trump victories, and the UK general election result earlier this year, the polls do not always get it right.

However, strengthening our conviction in a surprise-free result is the fact that when we look at the German crowd-sourced sentiment indicators, specifically government anger, we find they are supportive of the polls. Having peaked at historically elevated levels in February, (coinciding with a surge in support for the SPD after they named Schulz, former president of the European parliament, as their new leader[1]), government anger has fallen markedly and stands only slightly above its long-run average ie. neutral. This is not the sort of reading we would expect if Merkel was about to lose the election – see exhibit below.

Exhibit 1: Crowd-Sourced Government Anger Sentiment – Germany

Source: www.amareos.com

Assuming Merkel wins and serves her full four-year term, she will become the third-longest serving German Chancellor after Otto von Bismarck, and her political mentor, Helmut Kohl. Given the increasingly tense global geopolitical backdrop, Kim Jong-un’s ongoing game of nuclear “chicken” with the rest of the world being a current flashpoint[2], such experience is both greatly valued (hence Merkel’s comeback with German voters) and badly needed.

After all, experienced world political leaders are in short supply. The heads of government in the US, France and Italy have each been in their jobs less than a year. And, while the British PM has been in office longer (albeit not by much), she is hardly well-positioned to play the role of great international statesperson. Her credibility has been so gravely damaged by the disastrous June election result[3] that speculation over how long she will remain in 10 Downing Street remains rife. Plus, she and her government are distracted by the Brexit negotiations, which are going as badly as we feared they would[4].

The only area of doubt about the German election result is which other party (or parties) will join with Merkel’s CDU/CSU to form the inevitable coalition government – no single party has been able to dominate Germany’s “mixed member-proportional” system since 1957. In the last parliament there was a Grand coalition with the SPD, and even though the SPD is cautious about remaining the junior partner, their policies are not that dissimilar. That was clearly evident in last weekend’s TV debate between Merkel and Schulz, which was positively dull compared with the US and French presidential election debates.

Depending upon how the vote share ends up, even if a Grand coalition with the SPD does not materialize, Merkel could still govern by joining forces with the FDP, as she did between 2009-13, together with the Greens. The CDU/CSU and the FDP have a long history of working together in government (it has been the most frequent coalition in the post war period) and while there was previously some doubt as to whether the Greens would be willing partner in a Conservative-led government during their last party Congress a consensus formed in support of the “Jamaica” coalition – so named because the colours three parties involved match those of the Jamaican flag (Black/Yellow/Green). Hence, this month’s German election is almost certain to deliver a stable coalition government headed by a leader with considerable political experience.

Given the polls, this would hardly constitute much of a surprise for investors. Nevertheless, such is the state of the world at present, this combination probably will be viewed as a positive that warrants a premium, meaning the region’s asset markets should benefit on a relative – if not absolute – basis[5] (something that was not the case in the Eurozone for much of the past several years). It also provides a rationale for continued EUR strength at an important time for the currency.

Having gained more than 13% against the USD since January – a move in diametric opposition to the prevailing view of the majority of year-ahead predictions[6]  – there is increasing chatter that the rally may be running out of steam. There are two main reasons for this.

First, at close to 1.20 the current level of the exchange rate is in line with most economists (and their models) fair value estimates. Hence, the argument goes that the fundamental case for being long the EUR vis-à-vis the USD is no longer compelling.

Second, and more pertinent for the short-term outlook, publicly available estimates of market positioning suggest investors have accumulated a sizeable net long position. Since November, EUR short positions in CFTC non-commercial FX futures contracts have fallen sharply while EUR long positions have been steadily increasing. As a result, the net (long-short) EUR position has risen to multi-year highs – see exhibit below.

As many of our readers will appreciate, we are not fans of so-called market positioning estimates for the very simple reason that there is no such thing as an overall market position. For every buy there must be a sell and hence at the aggregate level everything nets to zero[7]. However, while a net market position is a logical impossibility, collectively the crowd can have an overall bullish or bearish opinion. Indeed, this is what we track using the crowd-sourced sentiment data.

Concomitant with the appreciation of the EUR, we find that the crowd has become more positive towards the single currency. Indeed, when we plot our crowd-sourced sentiment data for the EUR against the aforementioned CFTC data they show similar trends – see exhibit below.

Exhibit 2: EUR: Sentiment vs. CFTC Net Positioning (Non-commercial)

Source: www.amareos.com and www.quandl.com

However, we need to bear in mind that exchange rates are relative prices. Hence, we also need to take into account trends in crowd sentiment towards the USD. When we do this (by simply subtracting the two sentiment indicators) we find that crowd positivity towards EUR/USD is far from extreme. Although the crowd has become more positive towards the EUR over recent months, it is even more positive towards the USD (this has recently waned)[8], such that the differential is below its long-run average – see exhibit below.

Exhibit 3: EUR/USD Crowd-Sourced Sentiment vs. Price

Source: www.amareos.com

So, while FX futures positioning estimates appear to be concerning for the EUR/USD bulls, our crowd-sourced sentiment indicators point to something more benign – long EUR/USD is far from being an emotionally overcrowded trade. This is not the only reason why we remain constructive on this currency pair.

In a world where interest rates generally remain close to the zero bound, high capital mobility should imply that exchange rates are extremely sensitive to even modest changes in relative monetary policy stances[9]. Anecdotally, this perception is borne out by the strong USD appreciation witnessed over the preceding years as investors anticipated Fed Liftoff. More quantitatively, when we compare how the crowd views the relative interest rate outlooks between the Eurozone and US economies (again by simply subtracting the two sentiment indicators) we find that it closely tracks developments in the bilateral exchange rate – see exhibit below.

Exhibit 4: EUR/USD Crowd-Sourced Interest Rate Sentiment vs. Price

Source: www.amareos.com

Looking at the individual contributions, the latest rise in the interest rate outlook sentiment differential has mainly been driven by declining sentiment in the US as opposed to rising sentiment in the Euro zone. Indeed, sentiment shifts for the Eurozone interest rate outlook have been relatively modest over the past several months. This indicates that it has been changing public perceptions about future Fed policy that has been the bigger influence on the exchange rate. For investors expecting a more patient ECB – the main focus of last week’s policy meeting is any hints about tapering of the APP – to be the catalyst for a reversal in EUR/USD they are, therefore, likely to be somewhat disappointed[10]. Indeed, absent a more hawkish Fed, and there has been nothing in last week’s statements by two FOMC committee members that point to such a policy shift, the balance of probability favours continued EUR/USD upside.

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Amareos crowd-sourced sentiment indicators are based on  Thomson Reuters MarketPsych Indices

 

FOOTNOTES:

[1] The SPD’s decision to bring in Schulz at that time was a smart decision aimed at capitalizing on the negative social mood. It provided those who wanted to challenge the status quo with an acceptable alternative to the right wing populist AfD party because Schulz was a relative new-comer to German domestic politics but with impeccable pro-EU credentials. This ploy appears to have worked. During 2016 AfD gained strongly in the polls and were consistently in third place with a 15% vote share. However, since Schulz took over the SPD leadership, this has slipped back to 10%.

[2] As we touched upon in the previous Market Insight – see: https://www.amareos.com/financialresearch/the-market-sentimentalist-cock-a-doodle-doo/

[3] See footnote 2 above.

[4] See: https://www.amareos.com/financialresearch/the-market-sentimentalist-political-and-emotional-discord/

[5] Certainly we view the EUR (and the CHF) as more compelling safe haven currencies in the event of a serious escalation with North Korea than the JPY for reasons we cited in the Market Insight referred to in footnote 2 above.

[6] As we noted at the time – see: https://www.amareos.com/financialresearch/goodbye-2016-welcome-2017/

[7] In order to generate any market positioning estimate one necessarily has to choose to focus on one segment of the market – typically a specific investor type. In the case of the CFTC data the non-commercial transactions are considered a proxy for speculative traders.

[8] To be completely accurate there is marked divergence between the sentiments in mainstream and social media for the USD. The overall bullish sentiment reflects of the tone of social media because, in contrast, mainstream media is rather negative – a dissonance we referred to in an earlier Market Insight – see: https://www.amareos.com/financialresearch/the-market-sentimentalist-political-and-emotional-discord/

[9] By analogy, think of water in a large tray. Only a small change in the gradient leads to a very dramatic change in the distribution of the liquid within the tray.

[10] Knee-jerk weakness perhaps, but nothing more substantive in our view.

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