EUR/USD: end of the pain trade?

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    Written by Petr Krpata 12 April 2014

EUR/USD’s price action over the past quarters surprised many. While the cross’ resilience can be attributed to various factors, we think that most of them have now faded. Once the market starts pricing in tighter US monetary policy more aggressively, EUR/USD is likely to start depreciating on a sustained basis. We retain a bullish USD view.

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Since summer 2012, the performance of EUR/USD has constantly defied expectations. Since its trough of close to 1.20, it has appreciated by around 14%, currently trading just below the psychological 1.40 level. What has caused this appreciation and where we do see the cross going forward?

EUR crisis no longer the fundamental driver of EUR/USD performance

In October’s Compass, we discussed in detail the reasons driving EUR/USD’s resilience at the time, namely a material correction in the EUR risk premium (as the euro area existential crisis began to fade) and stable short-end interest rate spreads between the US and the euro area (thanks to the Fed managing to decouple expectations of QE tapering from rate hike expectations on the one hand, and the passive tightening of euro area monetary conditions as a result of LTRO repayments on the other).

However, given that the stabilisation of the EUR risk premium was the story of late 2012 and the first half of 2013, and that rate spreads suggest flat, rather than strong, EUR/USD (Figure 1), other factors must have driven EUR/USD higher in recent quarters.

Resilience driven by different factors in Q4 13 and Q1 14

It appears that euro area bank deleveraging supported EUR during late 2013. Banks sold their foreign holdings/assets and repatriated the proceeds back into EUR (while restricting overseas lending) in an effort to strengthen their balance sheets in preparation for the upcoming Asset Quality Review, leading to increased flows into EUR assets. Further, the Fed’s mixed messaging on the timing of QE tapering helped to weaken USD (the prime example being the September 2013 FOMC meeting, when the committee, against market expectations, did not announce a start to QE tapering, leading to pronounced USD weakness).

Figure 1 shows the EUR and the USD decoupled from rate spreads. Figure 2 the marked reverse in the US data surprise index.

However, with the repatriation story for euro area banks largely having played out over the last year (as the ECB’s AQR has been based on the state of banks’ balance sheets at the end of 2013), EUR resilience (and further modest appreciation) during the first quarter of this year is likely to have been attributable to other factors: a weak USD and a less dovish ECB.

The pronounced weakness in US data at the start of this year (due to the extraordinarily cold weather), coupled with high market expectations going into the new year, sharply weighed on USD. As Figure 2 shows, the Barclays US data surprise index moved from multi-year highs at the start of the year to multi-year lows – clearly, the extreme moves in actual US data outturns vs market expectations weighed on USD. Indeed, the dollar was not only weak against EUR, but across the board in trade-weighted terms (Figure 3). This, coupled with the ECB’s less dovish stance (despite euro area inflation at record lows, the latest estimate currently at 0.5%, the ECB has been reluctant to ease monetary policy further, pointing at anchored medium-term inflation expectations) has been supportive for EUR/USD.

USD strength, rather than EUR weakness will weigh on the cross…

We continue to hold the view that it will be the US dollar part of the equation that will drive the cross lower going forward. Specifically, a rise in US short-end rates (which so far have remained anchored unlike longer-term rates) stemming from market expectations of more imminent Fed Funds rate hikes should be a key driver of EUR/USD. These expectations are likely to gain traction as we get beyond the effects of cold weather, leading to “cleaner” US data which should point towards a strengthening economy.

Going forward, it will be primarily about the USD part of the equation and rate hike expectations

Moreover, core PCE inflation is likely to gain further importance in the light of the Fed’s recent adjustments to its forward rate guidance. Although inflation pressures have remained muted so far, our economists expect this to change and prices to rise closer to the Fed’s 2% target, driven by factors such as rising wage growth and continued increases in housing-related inflation.

A recovering economy and labour market, coupled with rising inflation, is likely to bring the Fed closer to rate increases. But while actual rate increases are likely to be a story for next year (our economists expect the first rate hike to occur in Q2 2015), the market, being forward looking, is likely to start pricing in such an outcome earlier. Hence, we expect USD strength to take hold during the second half of this year.

Figure 3 shows a graph of the weak USD, rather than a strong EUR. Figure 4 shows that Euro area inflation could remain low for some time.

… but a lack of EUR strength will help too

However, it always takes two to tango. When talking about EUR/USD, the outlook for EUR is equally important. While we do not expect EUR to collapse (as the euro area existential crisis appears well behind us), we anticipate euro area monetary policy will lag the US. As argued in our 2014 FX Outlook (FX 2014: The start of the “GMD”), we think that monetary divergences will be the crucial determinant for FX crosses in quarters to come. On this criterion, EUR clearly lags USD. While further easing by the ECB does not look imminent, the current historically low levels and likely future path of euro area HICP inflation (based on forecasts from both ourselves and the ECB – Figure 4) suggest policy will remain accommodative for an extended period of time. This should limit EUR upside.

Gradual EUR/USD downturn still our core view

But as seen over the past quarters, accommodative policy by the ECB is not on its own sufficient to weaken EUR/USD. The USD part of the equation also needs to take effect. Unless this happens, one should not expect material moves in EUR/USD. As per the above, we see scope for the market to begin pricing in a more hawkish Fed stance later in the year. This is reflected in our EUR/USD forecast, which points toward gradual EUR/USD depreciation: to 1.35 in 3 months, 1.30 in 6 months and 1.27 in 12 months.

While EUR is to underperform USD, European sovereign bonds look better placed

Weaker EUR/USD. But what about sovereign bond markets?

The primary driver for our expectations of a weaker EUR/USD is the prospect for earlier than expected monetary policy normalisation by the Fed. This would mean that yields in the US (particularly those on the short-end) should rise faster than those in the euro area (we expect the ECB to remain on hold for a very long time). This, coupled with a stronger and improved US growth and inflation outlook, should cause US Treasuries to underperform European sovereign bonds.

Not only should the wider euro area sovereign bond benchmark benefit from a dovish ECB (vis-a-vis the Fed), but the fact that peripheral bonds such as Italy and Spain have been trading as pro-cyclical assets (as Figure 5 depicts, they exhibit low correlation with US Treasuries, compared to their regional peers) is a further supportive factor for the benchmark given the stabilising growth environment - Italy and Spain account for 36% of the Barclays Global Aggregate Treasury Euro Area bond index. Indeed, improving growth prospects are supportive for these bonds as they lead to a reduced credit risk premium (the key concern regarding peripheral assets during the euro area crisis).

Figure 5 shows Peripheral bonds exhibiting different characteristics