Global Markets Research
Foreign Exchange: Strategy
2 April 2014,
Why has EUR been so strong?
We identify 8 reasons why EUR/USD has been so strong over the past year. Eurozone’s current account surplus is key.
We see a risk EUR/USD temporarily rises above 1.4000, but then eases toward 1.3600 year-end, remaining firm.
We are increasingly of the view that USD strength will be delayed until the real Fed funds rate turns positive in late 2016.
Consistent with our call twelve-months ago, EUR/USD has appreciated*. Many of our clients have asked us “why is EUR so strong?” Here we present the reasons for the EUR’s strength, followed by a medium-term outlook; which is for further EUR resilience, but limited upside above 1.4000. By year-end we see EUR/USD modestly lower, closer to 1.3600.
Why has EUR been so strong?
There are eight main reasons why EUR has been so strong:
1) Eurozone’s current account surplus.
The Eurozone is running a large current account surplus, equivalent to 2.3% of Eurozone GDP. The importance of a current account surplus in driving currency strength should not be under-estimated. The collapse in Japan’s current account surplus from a fifteen-year average equivalent to 3.1% of GDP, to less than 0.5% of GDP, is the major reason why the JPY has weakened in our view.
Despite the encouraging narrowing of the US current account deficit to 1.9% of GDP, the US current account deficit remains in direct contrast to the Eurozone current account surplus. The Eurozone current account surplus currently equates to average monthly net EUR buying of €18.7bn. This monthly net inflow into the Eurozone is up from near zero, two years ago.
2) Supportive Eurozone real yields.
The real Eurozone-US two-year bond spread remains very supportive for EUR/USD (chart 2). In fact the front-end of the real German yield curve remains higher than comparable real rates in the US, UK and Japan (chart 3). While the nominal Eurozone-US two-year bond spread is less supportive for EUR/USD strength, we prefer the real bond spread as guide to currency direction and strength. Eurozone inflation declined to 0.5% (YoY) in March generating higher (supportive) Eurozone real yields.
3) Diverging Eurozone & Fed balance sheets
While the monetary policy cycles of the US and Eurozone are in the early stages of diverging, the Fed and ECB’s balance sheets are doing the opposite of the perceived monetary policy divergence. Due to the policy decision of the ECB to accept early repayment of LTROs, the ECB’s balance sheet continues to shrink. In contrast, the Fed’s balance sheet continues to expand, and will continue to expand throughout the Fed’s entire tapering process.
4) Under-hedged Eurozone exporters.
Anecdotal evidence suggests Eurozone exporters are under-hedged. The ECB’s decision to cut the refi rate twice in the last twelve months (April 2013 and November 2013) generated expectations of EUR depreciation. Many of the large Eurozone exporters appear to have delayed converting USD export receipts into EUR. We sense that the appreciation in EUR above 1.3500 following the ECB’s November 2013 interest rate cut, and more recently, the lift in EUR/USD above 1.3950 has generated a “must buy-EUR-on-dips” mentality among many European exporters. We sense, there is more EUR/USD buying to be done, consistent with the very large Eurozone trade surplus. The very shallow and short-lived dip in EUR/USD following the lower than expected 0.5% Eurozone March inflation data release supports this view.
We also sense this is part of the reason ECB President Mario Draghi talked the EUR lower upon its recent spike above 1.3950; ECB President Draghi appears to be concerned a break in EUR/USD above 1.4000 would trigger stops and some panic-buying by Eurozone exporters, which could generate a spike in EUR/USD to 1.4300. An appreciation of EUR/USD towards these levels would put further downward pressure on the ECB’s inflation forecasts and mandate for price stability. We anticipate ECB President Draghi will again verbally talk down the EUR exchange rate should it again appreciate above 1.3950.
5) A softer than expected USD.
Despite the relative out-performance in the US economy and Fed’s steps to move toward monetary policy normalization, the widely anticipated USD appreciation has not materialized. In our view, a major reason for USD under-performance has been persistently negative US real rates. The USD is extremely influenced by the real Fed funds rate (and the real US two-year yield). The US current account deficit has improved. However, a current account deficit combined with negative real US short-end yields, it does not encourage currency appreciation. Net inflows into the US economy are not sufficient enough to strengthen the USD exchange rate.
6) Central bank reserve recycling.
The People’s Bank of China (PBoC) appears to have been actively recycling recently-accumulated USD reserves into EURs following their endeavors to lift USD/CNY some 3.0% since early January. Please see CBA FX Strategy: FX Reserve Re-Cycling & the USD, published 14 March 2014. This practice appears consistent with the PBoC’s long-held USD reserve diversification strategy.
7) Repatriation of Eurozone core banking assets
Eurozone banks have been repatriating capital for a number of years as they shrink their balance sheets, reduce offshore assets, and increase their tier 1 and tier 2 capital adequacy ratios. Eurozone banks have also being making strategic decisions to concentrate core banking assets inside Europe (home bias), rather than in Asia and the US. While a large number of large European banks have operations in non-European offshore locations, the recent practice has been to downsize those operations and repatriate the capital back to the core European business. The ECB data indicates that since January 2012, Eurozone banks have repatriated a net €250 billion.
8) European equity performance
European equities have performed well over the last twelve-months. In fact the relative performance of Eurozone equities has encouraged investor inflows and generated support for EUR/USD. We believe Eurozone equities will continue to perform well while the ECB maintains a commitment to keep interest rates at record low levels, and while nominal Eurozone GDP continues to recover.
Medium-term outlook for EUR
For a large collection of the previous eight reasons provided, we envisage EUR/USD should remain firm. However, our base case is that EUR/USD does not sustain a break above 1.4000. If we are wrong, and do get a break above 1.4000, expect a series of stops to be triggered and a subsequent spike in EUR/USD toward 1.4300. By year-end we see EUR/USD modestly lower, closer to 1.3600 for the reasons detailed below. But we stress that we see upside risks to our guidance of 1.3600 year-end because we are increasingly of the belief that USD strength will be delayed until the real Fed funds rate turns positive in late 2016.
1) Possibility of further ECB policy easing.
It may be premature to call an end to the ECB’s easing cycle. In our opinion, market participants may have failed to grasp the nuance of the ECB’s updated message in early March. The ECB continues to stress its easing bias, and by adding a reference to the “high degree of unutilized capacity” in its forward guidance. The ECB have reinforced that policy will remain accommodative even as the Eurozone economy picks up.
Based off the three-month EURIBOR curve, the market is pricing the first ECB rate hike in late 2015. However, incorporating the ECB’s latest Eurozone inflation and unemployment forecasts into a Taylor Rule estimate for the refi-rate, we find that policy tightening may be off the ECB’s agenda until H2 2016.
The ECB’s reinforced forward guidance and pledge to keep rates low even as Eurozone inflation and the economy pick-up is designed to push real Eurozone rates lower over time. With Eurozone inflation now down at 0.5% the risk of more stimulus has risen. If inflation does lift as per the ECB’s forecast, and/or if real Eurozone yields don’t fall, the ECB will more than likely provide further policy support.
2) A turn in the real yield spread
The currently positive real Eurozone-US two-year swap spread looks set to edge lower over coming quarters and turn negative from late 2014. This development should both limit EUR/USD upside and help guide EUR/USD lower.
By our estimates and using the Fed’s own inflation forecasts, the real US two-year US swap rate could turn positive in Q4 2014/Q1 2015, and the real Fed funds rate should turn positive by Q1 2016. By contrast, it is the ECB’s objective to get real rates in the Eurozone to turn negative over time. We envisage USD strength once the real Fed funds rate gets into positive territory. But the risk is a period of earlier USD strength once the US real two-year yield turns positive, somewhat ahead of the real Fed funds rate.
3) ECB likely to jawbone EUR lower should we re-visit 1.3950
While the ECB continues to stress that the EUR is not a policy target, the increasing number of policymakers who have referenced the EUR in their commentary illustrates how much of a focus the EUR exchange rate has become. ECB President Draghi explicitly stated that as the real interest rate spread between the Eurozone and the rest of the world falls, this should put “downward pressure on the exchange rate”. Draghi noted that EUR strength has dampened inflationary pressures and with inflation so low, the EUR has become “increasingly relevant” in the ECB’s assessment.
It is worth noting, as a general rule of thumb, the ECB estimates that for every 10% permanent increase in the effective EUR exchange rate, Eurozone inflation falls by 0.4%-0.5%pts. In its latest forecasts, the ECB assumed EUR/USD remains constant at 1.3600 over the forecast horizon. It would not take much of a sustained EUR appreciation above the current 1.3600 forecast assumption for the ECB’s inflation forecasts to be challenged.
4) Eurozone banks are likely to slow asset repatriation
Eurozone banks have been downsizing non-European offshore operations for a number of years now. The contraction in these European offshore balance sheets and subsequent repatriation back to the Eurozone is likely to be slowing. Furthermore, the repatriation of cash into the Eurozone ahead of the ECB’s 31 December 2013 stress test deadline has now passed.
We see eight reasons why EUR/USD is strong. Furthermore, we see a risk that EUR/USD breaks above 1.4000 (and spikes to 1.4300) but we don’t envisage EUR/USD to sustain a move above 1.4000. By year-end, we see EUR/USD mildly lower at 1.3600. But we maintain there are upside risks to this view.
The dampening pressure on the EUR, should further ECB easing in monetary policy occur, is likely to be offset by the Eurozone’s current account surplus. Low inflation and low nominal interest rates are not necessary a prescription for currency weakness when a country maintains a healthy current account surplus; as Switzerland and to a lesser extent, Japan, can testify.
One of the biggest risks to the EUR/USD exchange rate outlook would appear to be the USD. Our view is that USD strength is delayed until the US real Fed funds rate turns positive (in late 2016). But the risk is the USD strengthens once the US real two-year yield turns positive, somewhat ahead of the real Fed funds rate, in late 2014/early 2015. While USD strength is delayed, EUR/USD will remain firm.