Weekly FX – The resilient euro

by: Georgette Boele

We have revised our forecasts for EUR/USD significantly higher, though we still expect the direction to be lower. We think that up to the fourth quarter of 2014, euro supportive drivers such as demand for peripheral bonds, LTRO repayments and selective safe-haven support will partly offset the impact of a strengthening of US economic data on the cross, resulting in only a modest fall. However, we expect a stronger appreciation of the USD versus the EUR in Q4 2014, which will gain momentum in 2015, as the USD cyclical drivers and in particular Fed rate hike expectations become increasingly dominant.

Revisions to our EURUSD forecasts

For almost nine months now, the EUR/USD has defied our expectations that a downward trend would take shape1. Euro supportive factors have had a bigger impact than previously expected, while the ECB has been more tolerant of lower inflation than we thought it would be. As such, we have revised our forecasts for EUR/USD significantly higher, though we still expect the direction to be lower. We think that up to the fourth quarter of 2014, euro supportive drivers such as demand for peripheral bonds, LTRO repayments and selective safe-haven support will partly offset the impact of a strengthening of US economic data on the cross, resulting in only a modest fall. However, we expect a stronger appreciation of the USD versus the EUR in Q4 2014, which will gain momentum in 2015, as the USD cyclical drivers and in particular Fed rate hike expectations become increasingly dominant. This will result in a lower EUR/USD.

 

Sentiment on the eurozone matters…

Over the year, the EUR Trade Weighted Index (TWI) has developed a strong negative correlation with eurozone sovereign risk and euro break-up risk more generally, as captured by sovereign CDS spreads for Italy and Spain. In other words, when investors started to become more concerned about the future of the single currency area and the risks of peripheral sovereign defaults, reflected by wider sovereign CDS spreads, the euro moved lower. But since the famous Draghi speech in July 2012 announcing the ECB OMT programme, sentiment has dramatically improved, which has given a strong support to the euro.

The turnaround in sentiment opened investors’ eyes to the opportunities in the eurozone bond markets. With significantly lower systemic risk, yields on peripheral bonds looked very attractive. This has resulted in a flight into, for example Spanish government bonds, leading to the narrowing of spreads over Germany. Flows did not only come from eurozone investors, but also from foreign investors supporting the EUR. The single currency area not only offered EUR investments for risk averse investors (German Bunds), but also investments for risk seeking investors seeking yield.

 

Over the coming quarters, we expect spreads between Italy/Spain and Germany to narrow further. As a part of the demand may come from non-euro based investors, the euro will continue to be supported by these investor flows. However, significant part of the move is behind us.

…and banks cleaning up their balance sheet also support

Over the past year, banks have been cleaning up their balance sheets and have become less dependent on ECB liquidity as funding markets thawed. This manifested itself in the sale of foreign assets and repayments of LTRO funds. The former led to flows into euros, though eurozone bank external assets have recently stabilised. Meanwhile, LTRO repayments have meant that the excess liquidity is the financial system fell sharply and this put upward pressure on short-term interest rates. Indirectly this also supported the EUR. The maturity for the first three-year LTRO is 29 January 2015 and 26 February 2015 for the second LTRO. The repayment of the LTROs will likely result in a further shrinking of the ECB’s balance sheet, though some of the impact might be offset by banks switching to the ECB’s other refinancing facilities, which will be at full allotment through the middle of next year or longer. Overall, we think that LTRO repayments will continue to be a euro-supportive factor in coming months.

 

Reluctance by the ECB to ease monetary policy in the near-term will haunt the EUR in 2015

The market is disappointed about the ECB’s reluctance to ease monetary policy further. On the one hand, many time comments from ECB officials have hinted in the direction of more aggressive steps to come. On the other hand, Mr Draghi has repeated his mantra that the central bank is closely watching the developments, is standing ready to act, while taking no policy action. The market has thrown in the towel on further ECB monetary easing and so have we. Even though we expect inflation to fall further and to come in even lower than the central bank expects, it is proving to be more tolerant of lower inflation than we expected. The ECB’s approach is in our view complacent and raises deflationary risks, but as long as a gradual economic recovery continues, it should get away with this gamble. Overall, we no longer expect monetary policy easing this year, which is in line with market expectations. So, this driver has become neutral for EUR/USD. However, the consequence of no monetary policy easing in the near-term is that inflation continues to move lower (especially given a strong euro) and that the ECB will likely stay on hold with interest rates for even longer. This policy will seriously hurt the EUR versus the USD once the market starts anticipating Fed rate hikes. We expect expectations to build in from Q4 of 2014.

Selective safe-haven demand unlikely to stay…

Before the introduction of the euro, tensions and/or developments in Russia as we now have regarding Ukraine, would have been negative for the Deutsche Mark. This year, we have not seen any of this. In fact, the euro appears to receive some kind of safe-haven support from the tensions between Ukraine and Russia. This has manifested itself in a positive correlation between equity market volatility (VIX) and the EUR Trade Weighted Index. However, the overall sentiment in currency markets has been quite constructive. For example, there are no signs of risk aversion reflected by a strong rally in the Japanese yen or the US dollar. Moreover, emerging market currencies have done relatively well. In the near-term, tensions between Ukraine and Russia could continue to provide some support to the EUR. But we expect this impact to fade as we do not expect full-blown crisis. In fact, such escalation would result in risk aversion in financial markets supporting the JPY and the USD.

 

…and US dynamics to take over later this year

US economic data have let us down at two crucial points in time. In the second half of 2013, the US economy was gaining momentum, which should have been dollar supportive. But this momentum was interrupted by the US government shutdown. Then it took some time to regain this momentum and the market to react on it. But again the momentum in US economy was abruptly disrupted. This time around, unusually cold weather is the culprit. Both unexpected disruptions came at a crucial time for the US dollar, which was about to start rallying. We are very positive on US cyclical prospects and think that economic data will turn up sharply as the weather returns to more normal patterns, which appears to be happening this month. This turn in the data should support the dollar, but the impact on EUR/USD will be partly offset by the euro positives described above. Ultimately however, we think that the dollar positives will increasingly dominate later this year, driven by the expected divergence in monetary policy on either side of the Atlantic. We hold an above consensus view on US interest rate hikes in 2015 and US economic growth in 2014 and 2015. We expect the Federal Reserve to move from the middle of next year, but market expectations will likely start to seriously build from Q4 of this year onwards. This should be the trigger for a more decisive turn in the dollar. At that point, positive medium-term fundamentals such as an improvement in the fiscal balance, a sustainable current account deficit, and attractive valuation will likely add to the greenback’s momentum. Overall, we expect the EUR/USD to decline much more modestly in the coming months than previously, but it should move more significantly lower in 2014 Q4 and in 2015 (see table).

 

1This note first appeared as part of our FX Monthly last week.