EUR/USD: Good things come to those who wait (eventually)

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Last month, we looked in some length at the resilient pound. This month, we turn to the euro (EUR), whose strength against the dollar (USD) has puzzled the market. In our view, short-term interest rates help explain support for EUR. But this should change next year and we expect EUR/USD to fall below 1.30 again.

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Weaker euro area growth relative to the US, a dovish European Central Bank (it cut rates this year and introduced forward rate guidance), a more favourable US monetary policy outlook and ongoing divergences among euro area economies (core vs. periphery) all suggested a weaker EUR. Yet the reality has been different. Not only has EUR/USD remained resilient (and appreciated) throughout the year, it spiked after the surprising decision by the Federal Reserve (Fed) to maintain its current level of quantitative easing (QE). What, therefore, has driven EUR/USD resilience, and where do we see it going?

Euro’s resilience and its causes

In our view, two factors have played in EUR/USD favour so far this year: declining EUR risk premium and, perhaps more importantly, resilient EUR rates and rate spread against USD (we expected the former, but not the latter).
While most of the normalisation in the perceived EUR risk premium happened in the second half of 2012 (Figure 1), the currency has continued to benefit from its tailwinds this year. The euro is no longer being seen as a distressed asset.

But with EUR break-up risk largely priced out early this year, the currency‘s key drivers have changed. Figure 2 shows various financial variables and their correlation with EUR. In recent months, the importance of EUR-specific risk measures have declined (such as iTraxx European Bank CDS index or Italian and Spanish yield spreads vs. Germany), while the importance of the relative euro–US rate spread increased. In other words, it is now the relative rate spreads, and not the euro break-up risk, that drives EUR/USD.

In terms of relative rate spreads, 10-year rates are now showing high correlation with EUR/USD (Figure 2), but as Figure 3 depicts, it only gained importance very recently. In past quarters, the 2-year rate spread showed more stable properties. Here lies the key to the EUR/USD resilience puzzle. Because the short-term interest rate gap has remained contained in 2013 (Figure 4), and did not move in USD’s favour, EUR/USD did not fall.

Why have the short rates (unlike those on the longer end) not moved into USD’s favour? We see two reasons:
First, the Fed managed to make a distinction between QE tapering and rate hikes. So, while the market expected a slow withdrawal of QE (which, as we learned on 18 September, has been postponed), it did not necessarily expect the fed funds rate to rise imminently. Hence, US short-term rates did not rise materially.

Second, despite the dovish European Central Bank (ECB), short-end rates in Europe remained underpinned and have actually risen somewhat. While improving euro area data are part of the story, the other factor is a passive tightening of euro area monetary conditions. This has happened due to local banks repaying LTRO funds they previously borrowed, resulting in lower surplus liquidity in the euro system. This drove short-term rates higher (interbank rates such as Euro OverNight Index Average rate, Eonia – Figure 5), benefiting EUR.

Valuations suggest medium-term downside to EUR/USD

EUR/USD to remain range-bound in months to come

With QE postponed, rates are unlikely to move materially into USD’s favour for now. Additionally, concerns about the US government shut-down or the likely nomination of current vice chair Janet Yellen (perceived as a dovish candidate) for the Fed’s top job may cause rates to temporarily fall further. We, therefore, expect EUR/USD to remain range-bound for the time being and not materially deviate from current levels.

Furthermore, stabilising euro area economic data and their effect on local assets are likely to provide a near-term floor under EUR/USD. In the developed market (DM) sovereign bond space, European peripheral debt is currently one of the most attractive assets, in our view (though inherent political uncertainly in the region may cause some volatility time to time – as seen over the past two weeks). It offers attractive carry, is denominated in a relatively low-volatile and cheap-to-hedge currency (EUR), trades as a pro-cyclical asset and, unlike its peers in the US or Germany, is less susceptible to sell-offs as the global economy improves.

On the equity side, our strategy team sees continental Europe as one of the most attractive investment regions in the developed world (valuations are undemanding, the euro area economy is gradually improving and this should be reflected in a better earnings outlook), making it a potential destination of inflows. Indeed, foreign investors have been net buyers of European equities so far this year. All this is supportive of EUR for now and should prevent a significant fall in EUR/USD.

Next year EUR/USD to trade below 1.30

While it is hard to see EUR/USD weakening materially in the weeks and months to come, we expect it to depreciate next year and fall again below 1.30. In our view, the key to sustained EUR/USD weakness is diverging monetary outlooks and short-term rates moving into USD’s favour. So far, we have experienced the former, but not the latter. We would expect short-end rates to move in USD’s favour once QE tapering is underway and the market starts entertaining the idea of eventual and more imminent US rate hikes.

Granted, the Fed indicated in its latest projections that it only expects the first rate hike to occur in 2015 and the fed funds rate to gradually rise thereafter, potentially reaching a “natural rate” of 4% “two or three years after 2016”. However, once QE ends – and provided the US economy continues on its recovery path (as we expect) – the Fed forward rate guidance may face the same limits as that of the Bank of England (BoE) – the market may take its own view (as it did in the case of the BoE and UK rates outlook) and start building in expectations of earlier and bigger rate hikes.

Indeed, should the unemployment rate continue falling at the same pace it has so far (regardless of whether it is due to a falling participation rate or to strong job creation), the market will be expecting a monetary response. It is simply hard to see employment and the economy reaching its full potential (which the Fed expects to be in 2016) and the policy rate not being at, or very close to, its natural levels. And this will remain the case largely regardless of how dovish the next Fed chairman will be.

In contrast, we expect the ECB to lean more actively against higher short-end rates, particularly if the trend of recent months (short rates rising) continues. The divergences among member states still remain, while the ECB is particularly concerned about commercial banks not lending to the private sector (Figure 6). This, coupled with a very subdued outlook for euro area inflation (we expect it to be only around 1.3% next year - Figure 7), may cause the ECB to retain its dovish bias. Our economists expect the bank to introduce Very Long-Term Refinancing Operations (VLTRO) this December, which should keep euro area short-end rates anchored. We therefore expect euro area and US monetary policy to diverge, not only in their outlooks (as they have done so far), but in actual effects on rates. This should ultimately weigh on EUR/USD

Needless to say, USD’s properties are changing. The currency is turning pro-cyclical – shifting from being perceived as a funding currency to an investment currency. This should benefit USD over the quarters ahead. On the one hand, the natural selling pressure USD was under (by virtue of being seen as a funding currency) will wane, while it should receive support of inflows due to the attractive domestic investment opportunities - which are associated with the strong economy. Indeed, as Figure 8 shows, USD/EUR correlation with risk is now close to zero, suggesting that EUR loses (against USD) the tailwind of appreciating in a risk-friendly environment.

Valuation

In terms of medium- to long-term valuations, we see modest downside to EUR/USD. Purchasing power parity suggests that EUR/USD is currently 7% overvalued against USD (with fair value at 1.27). Our behavioural equilibrium exchange rate (BEER) model points at a lower fair value level, at around EUR/USD 1.20, one and a half standard deviations away from the current spot, suggesting downside to EUR/USD over the quarters ahead.

Summary: Sticking to EUR/USD downside view

Overall, we continue to see downside to EUR/USD over the medium term. The cross’ downward sloping trend should unfold once the market starts building more imminent expectations of higher US rates. However, this is likely to be a gradual process that will probably kick in next year, rather than this year. We would use any further bouts in EUR/USD strength in coming weeks/months to establish short positions. Our FX forecast pencils in EUR/USD at 1.32, 1.30 and 1.27 in 3, 6 and 12 months respectively.

That said, our highest convection medium-term trade remains long USD/CHF, which we see as a leveraged version of EUR/USD. With EUR/CHF trading close to its floor, CHF’s upside is limited. In contrast, its downside is meaningful, particularly in the context of an improving euro area economic outlook and dissipating EUR risk premium. We, therefore, see more material upside in selling CHF (rather than EUR) against USD.