Today’s CIO Weekly Perspectives comes from guest contributor Ugo Lancioni.
When the European Central Bank adopted a much more hawkish tone on February 3, it gave the EUR/USD exchange rate a substantial boost. A week later, a 7.5% U.S. inflation print, followed by some exceptionally hawkish statements from U.S. Federal Reserve officials, led to some very volatile price action.
We think the ECB’s change of tone is significant, bringing us closer to a situation where economic and technical dynamics are more fully aligned with a stronger euro. As such, Thursday’s tug-of-war around current levels suggests to us, not a renewed threat to EUR/USD, but a signal that a base is being built underneath it.
On this Valentine’s Day, the market may be ready to commit its affections to the euro.
That would be a big change from last year’s Valentine’s Day, when the market left the single currency hanging.
The EUR/USD exchange rate started 2020 at 1.10. By February 14, 2021, it had risen above 1.20. Over the course of the rest of the last year, it came all the way back down to 1.12. The euro has risen and fallen depending on which economic or technical dynamic the fickle foreign exchange market has been focused on.
During 2020, it focused on why the euro looks undervalued against the U.S. dollar, particularly on a long-term view.
For example, real effective exchange rates and purchasing power parity (PPP), which take into account what a euro or dollar can buy locally, suggest that the nominal EUR/USD rate is between 10% and 15% undervalued.
Relative current account balances also strongly favor the euro. The eurozone has a surplus of almost 3%, the U.S. a deficit of more than -3%.
Interest Rate Differentials
Once the recovery from the pandemic reintroduced the potential for tighter monetary policy, however, the market moved its focus to interest rate differentials.
This pulled the euro out of favor. While the U.S. Federal Reserve and other central banks grew more hawkish, the ECB seemed reluctant to give up on the idea that the spike in inflation would prove transitory. In the second half of 2021, especially, the euro began to move in lockstep with the spread between euro and dollar rates.
At the same time, a combination of strongly outperforming U.S. equities and the swath of negative-yielding European bonds kept capital flowing westward across the Atlantic. Many of the long-euro positions built up during 2020 were unwound.
That is why ECB President Christine Lagarde’s hawkish comments on February 3 are important.
Lagarde emphasized that inflation risks were “tilted to the upside,” and chose not to repeat her previous assumption that a rate hike this year is unlikely. A couple of days later, Klaas Knott became the first ECB governor to forecast a 2022 hike. Negative consequences for peripheral eurozone credit spreads led to some message moderation last week, but in our view the change of tone is clear.
For a week, it helped to narrow U.S. dollar and euro interest rate differentials—until Thursday’s U.S. inflation data and Fed hawks sent U.S. yields soaring. But the reason we think the euro could build a base at current levels is that the change of tone at the ECB could lead investors to shift their attention back to factors other than rate differentials.
What might those factors be?
First, when we start to consider hiking rates from below zero, we believe it’s not only rate differentials that are important, but European rate levels. It’s worth noting that, according to Bloomberg data, the value of negative-yielding assets has more than halved since the start of the year, from $11 trillion to $5 trillion. A large proportion of those assets are European.
ECB data suggest that capital flows out of Europe, mostly into U.S. dollar assets, started to pick up speed when the central bank cut rates below zero in June 2014. Due to negative euro rates and wide rate differentials, some of the capital that went into U.S. fixed income, and most of what went into U.S. equities, is likely to have been unhedged. Moreover, some investors’ mandates prohibit them from investing in negative-yielding assets.
We see growing incentives to implement hedges or reverse those seven years of flows, creating balancing demand for euros.
Second, looking past headlines such as January’s payrolls number and inflation, recent U.S. economic data has surprised on the downside, especially relative to Europe’s. Consensus growth estimates for 2022 now have the U.S. at 3.8% and the eurozone at 4.0%. Tighter financial conditions could make things more difficult for peripheral eurozone borrowers, but we are not in 2011 anymore; the collectively financed NextGenerationEU pandemic recovery plan has substantially reduced perceptions of eurozone break-up risk.
And finally, there is the unspoken importance of exchange rates for the ECB’s price-stability mandate. As we know, central banks have refrained from targeting currency levels, but they do matter for inflation. When inflation is well below 2% and oil is $60/bbl, a weak currency is desirable. With oil at $90/bbl and inflation at 5%, a stronger currency would help to ease the pain of Europe’s energy import bill.
Add it all together, and we believe the euro is building a base at current levels. Should U.S. rates stabilize, and especially if we see U.S. growth begin to lag global growth, we think there may be upside to come.
Will there be difficult, volatile moments? Most likely. Thursday gave us a taste of the potential for U.S inflation and policy surprises. But aren’t all love affairs volatile from time to time? Ultimately, we think the euro and the market are laying the foundation for a long and happy relationship.
In Case You Missed It
- U.S. Consumer Price Index: +0.6% in January month-over-month and 7.5% year-over-year (Core CPI increased 0.6% month-over-month and 6.0% year-over-year)
- U.S. Initial Jobless Claims: +223,000 for the week ending February 5
What to Watch For
- Monday, February 14:
- Japan 4Q 2021 GDP (Preliminary)
- Tuesday, February 15:
- U.S. Producer Price Index
- Eurozone 4Q 2021 GDP (Second Preliminary)
- Wednesday, February 16:
- U.S. Retail Sales
- NAHB Housing Market Index
- Thursday, February 17:
- U.S. Housing Starts and Building Permits
- U.S. Initial Jobless Claims
- Japan Consumer Price Index
- Friday, February 18:
- U.S. Existing Home Sales