Why the Euro will come roaring back

Yvan Berthoux - 14 June 2018

US Dollar bulls have been on the rampage in recent weeks, with many observers expecting further appreciation of the greenback due to slowing European fundamentals, EM carry trade wipe-outs and a rise in US Dollar funding costs, but there are some powerful arguments that support the revival of the Euro.

The single currency appears to be significantly undervalued according to some FX ‘fair’ value metrics. For instance, if we look at the Purchasing Power Parity (PPP) measure published yearly by the Eurostat-OECD, the exchange rate is currently valued at US$1.34 (or 12 per cent undervalued). In addition, the Real Effective Exchange Rate (REER) for the Euro computed by JP Morgan, it stands 6 per cent undervalued in comparison to its long-term average. While currencies can diverge significantly from their fundamental values for a considerable amount of time, the easing of political uncertainties should allow a favourable consideration of the Euro in the weeks ahead.

There are several short-term drivers of currencies, which are changing all the time depending on the market conditions. The most popular one is the interest-rate differential between the two countries (either the 2Y or the 10Y). Currencies with higher interest rate should appreciate relative to currencies with lower interest rate, a strategy named as carry trade, which has historically generated positive returns on average. However, it is important to note that for the past 12 months, the relationship between IR differentials and major currencies has been inexistent. Figure 2 (left frame) shows the development of the EURUSD exchange rate overlaid with the 2Y US-DE IR differential; we can notice a strong divergence since the second quarter of last year.

Beware the twin deficits

The US is expected to accumulate budget deficits of US$12 trillion over the next decade, which will elevate the debt (held by public) from 76.5 per cent to 96 per cent, as a ratio to GDP. This deterioration will continue to weigh on the US Dollar in the medium term. Figure 2 (right frame) shows an interesting co-movement between the fiscal and external ‘twin’ deficits and the REER of the US Dollar. As a reminder, the Eurozone is expecting a 4 per cent of GDP current account surplus for 2018, while the US deficit is expected to decline towards 3 per cent. Hence, the current account differential will tend to weigh more on the exchange rate than the interest rate differential.

Not forgetting the existential risks for the Euro

Whatever the merits of the Euro – structural undervaluation, excellent external position and improving sentiment – the eruption of political instability in Italy, evidenced by a jump in Italian government bond spreads, reminds us that an existential threat to the Euro lurks in the shadows. Even though we don’t see any imminent threat coming from the periphery, if the ‘rebellion’ in Italy intensifies, we could see widening spread between the BTP and Bund that would eventually be negative for the Euro. This would be a scenario ‘a la 2012’, when Spanish and Italian benchmark government bond yields traded at 7.5 per cent and 6.5 per cent, respectively.

After hitting a low of US$1.1525 on May 30th, the Euro is up 2.5 figures flirting with US$1.18. An extension of this recovery is the most likely scenario, bringing the Euro back into the US$1.21 – 1.25 range where it traded in the first quarter of the year.

Figure 1

Data source: EuroStat-OECD, Eikon Reuters

Figure 2

Data source: Eikon Reuters, Trading Economics

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