Macro Weekly FX – ECB changed the game for the euro

door: Georgette Boele , Roy Teo

The ECB’s decision to cut the deposit rate into negative territory has seriously dented the attractiveness of the euro. As a result, the negative relationship between peripheral spreads and EUR/USD has broken down. We expect further euro weakness in the months ahead against the dollar in particular. Meanwhile, we have removed sterling versus the euro from our top pick list, given that the upward adjustment in UK rate hike expectations is advanced, and sterling has already rallied strongly.

 

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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 currencies (only the Swedish krona and the Canadian dollar have performed worse).

 

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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 1.35. 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 it 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, Swedish krona and Polish zloty.

New Zealand dollar outperforms…

The New Zealand dollar (NZD) rallied by 2% versus the US dollar last week and was the outperformer in our FX coverage (including emerging markets). The Reserve Bank of New Zealand (RBNZ) hiked official rates by 25bp to 3.25%, which was widely expected. However, the market was expecting the RBNZ to signal that the pace of future rate hikes might slow given the strength in the currency and moderation in house price and credit growth. On the contrary, the central bank maintained its hawkish tone that the pace of monetary tightening this year will continue as previously assessed. As a result this gave a boost to the NZD as the market readjusted its rate hike expectations. This is reflected by an upward shift in the curve of the 3-month bill futures compared earlier this month (see graph below). Looking ahead, given economic growth and inflation in 2015 is likely to be slower than previously envisaged, we have lowered our 2015 year end official cash rate expectations by 25bp to 4.50%. On the currency front, we do not expect gains above 0.87 to be sustainable due to weaker dairy prices. In addition further gains in the currency is likely to push down inflation (due to lower tradable inflation) resulting in a more dovish RBNZ stance. We maintain our view that the NZD will ease towards 0.82 against the US dollar later this year.

 

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…and so did sterling…

Sterling rallied strongly on the back of Mr Carney’s remarks and the subsequent factoring of rate hikes (see Rates section in this publication for more). As a result, our year-end forecast of 0.80 in EUR/GBP was breached. Short euro and long sterling has been one of our high conviction views (as communicated in our FX Monthly of 20 November 2013). Given the change in our BoE view and recent market moves, we have lowered our year-end forecast for EUR/GBP to 0.79 (from 0.80) and we have also adjusted the path of sterling appreciation. However, our year-end forecast for 2015 remains unchanged at 0.75, as we have also left our target for the BoE rate at the end of that year intact.

…removing sterling from high conviction list

Despite these adjustments in forecasts, we have decided to remove sterling from our list of high conviction currencies. This conviction had been expressed versus the euro as short EUR/GBP, on the view that economic growth and monetary policy differentials would widen. This scenario has played out convincingly and we close the call with a 5% total return. The reason we have decided to do so is that markets have now gone a long way in pricing in the scenario of the BoE being the first major central bank to raise rates. Even though it is likely that market interest rate expectations will be adjusted further upwards, most of this adjustment looks to have already taken place. Therefore, the upside in short-term interest rates and the sterling is relatively limited in the near term. Market positioning fully supports this view. Speculative net sterling long positions in the futures market are close to a five year high. It is likely that these positions will dampen sterling’s upside. In fact, they make sterling vulnerable and could lead to asymmetric reactions to events and data. For example, if news or data are somewhat less favourable, investors could take profit on their positions resulting in a substantial downward correction in sterling. On the other hand, upbeat data confirming the scenario but not exceeding expectations, may start to gain increasingly less traction on the currency. On balance, the risk-return trade off no longer favours sterling.

 

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Emerging market currencies were mixed

Emerging market currencies showed a mixed performance last week. On the one hand, currencies from the larger emerging markets such as Brazil, China and Russia did relatively well. They were able to outperform the US dollar last week. The Brazilian real was supported by news that the central bank will continue to intervene in FX markets. Authorities seem to prefer FX interventions to further increases in interest rates to fight inflationary pressures. The Chinese yuan outperformed, because authorities continue to take measures to support the economy. In addition recent economic data has shown some signs of improvement. This has supported investor sentiment with the currency trading at a smaller discount to the daily fix. We are increasingly confident that the yuan has likely troughed at 6.27 against the US dollar with potential gains towards 6.17-6.18 in the coming months. Nevertheless, we maintain our view that any sharp gains in the yuan will not be tolerated by the central bank.

On the other hand, other emerging market currencies did not that well. For example the Turkish lira and South African rand lost a bit more than 1%. (Geo) political developments in Iraq have dented the sentiment on the lira, while the downgrade of South Africa by S&P (with stable outlook) hurt the rand.

 

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