Source: screen grab of footage from Fox Business News
Source: screen grab of footage from Fox Business News

New York Fed President William Dudley sent the euro into a tailspin this morning with a declaration that the US expansion has a long way to go.

Dudley’s “that’s-my-story-and-I’m-sticking-to-it echoed Fed Chair Janet Yellen’s claim that the unexpectedly (to the Fed) low inflation reports of the past three months are the chance result of “idiosyncratic” events which all conspired to make the Fed look wrong. The risk, of course, is that the Fed will continue raising interest rates and reducing the size of its balance sheet in the belief that inflation is coming back, when the economy remains week and plagued by “lowflation.”

Dudley’s remarks had a big effect in the currency market, a minor effect on the bond market (where the 10-year note is down by less than a quarter of a point and the 30-year bond unchanged), and no effect on the stock market, which rallied happily.

There are different things at work. American investors are massively underinvested in European equities after years of superior performance by the S&P, and inclined to increase their positions. But long euro-short dollar is the world’s most crowded trade, given unexpectedly strong European economic performance, the emergence of a new European political consensus with M&M (Merkel and Macron), and the inevitable end to negative interest rates in Europe some time in 2018. Even Chancellor Angela Merkel says she wants the Euro to rise.

A short position on the euro, though, anticipates a future rise in German interest rates. For the time being investors have to pay to short the euro. Nothing is likely to happen in European monetary policy until December at the earliest, so there is no rush to short the dollar against the Euro–but everyone did anyway, and then bailed out when Yellen sounded more hawkish than expected at last Wednesday’s Fed press conference.

The short crept cautiously back in and fled when Dudley’s comments came across the tape this morning. Nonetheless, European equities (particularly northern European) offer better value for money and probably better growth prospects than their American counterparts, so European markets continued to rally, with Germany’s DAX index up about 1%.