- Negative interest rates and strong forward guidance are headwinds for the euro…
- …we remain negative on the outlook for the euro versus the dollar, sterling, krona and zloty
- China cuts again the RRR for certain financial institutions, in a new sign of targeted support
The euro is losing its shine
From ECB President Draghi’s famous speech in July 2012 up to the ECB meeting on 8 May, the euro attracted substantial investment flows, which were directed into peripheral bonds. This was due to the reduction of systemic risks and the overall improvement in eurozone sentiment. This was reflected by tighter peripheral bond spreads over Germany and a higher euro (see graph). So the euro was supported by investors searching for yield in an overall positive investor climate. Since 8 May (red vertical line), the market has changed its view on the euro. As a result, the euro has been one of the worst performing currencies among major and emerging market currencies (only the Swedish krona, the Swiss franc, Czech Koruna, Hungarian forint and South African rand have performed worse).
What was the trigger for this? On 8 May the ECB signalled that more monetary stimulus would be announced at the 5 June meeting, including negative interest rates. This has resulted in a fall in EUR/USD from 1.40 to 1.36. Last Thursday, the ECB surprised financial markets by announcing a more substantial package of unconventional measures. This has seriously undermined the euro. News headlines have branded the euro as a ‘funding currency’ ever since. We disagree with this characterisation. In fact, the euro’s character has not changed at all. For example, the euro has continued to be driven by developments in interest rate markets and the monetary policy stance. Its correlation with 2y and 10y German yields have been positive for quite some time. Lower rates have pushed down the euro. What did change, however, is its relationship between the euro and the VIX, which is now strongly positive. This is not a reflection that the euro is a safe-haven currency, but merely a reflection that negative official rates in a more risk seeking (read yield-searching) environment is simply bad for the euro. The carry attraction of the yield pick-up in eurozone periphery may still continue and this will push the spreads over Germany lower. This, however, looks to be driven by domestic investors locking in to attractive yields. Negative official rates have made the euro unattractive for non-eurozone investors. Therefore, the relationship between the euro and periphery spreads over Germany has turned positive (see graph). The ECB’s forward guidance that rates will remain low for a long time means the euro is now a currency to avoid unless you want to borrow. We remain negative on the euro versus the US dollar, pound sterling, Swedish krona and Polish zloty.
China still fine-tuning monetary support
Meanwhile, China’s authorities are continuing their targeted support and announced a second round of reserve requirement ratio (RRR) cuts to support the rural sector, SMEs and consumption. The intention remains to reduce costs for the banking system so that they could channel credit to specific activities. The RRR cut of 50bp to qualified banks covers not only rural commercial and rural cooperatives, but also two-thirds of the city commercial banks if they are lending to the agricultural sector or SMEs. This measure, which will be effective 16 June 2014, comes in addition to the 200bp RRRs for county-level rural commercial banks and 50bp cut for rural cooperatives announced on 22 April. Although it is still uncertain what the impact on liquidity will be, initial estimates suggest that it could amount to RMB 50-70 bn. A 50bp system-wide cut in RRR would increase liquidity by six times this amount. Our view is that this measure is again a signal that the authorities are willing to give support to some key sectors, but that no significant liquidity loosening is on the cards. This suggests that they remain determined to avoid the risks of rapid credit expansion. Meanwhile, CPI inflation in China rebounded in May to 2.5% yoy up from 1.8% the previous month. Food prices rose by 4.1% yoy, mainly driven by pork prices, which rose strongly in early May. Our forecast for inflation in 2014 is 2.8%, lower than the 3.5% official target.