"The expectation of ECB policy easing has obviously been positive for euro area fixed income markets. Yields on short-dated notes are at record lows and the medium to long end of the market has been very well supported. The relationship between the German yield curve (10yr vs repo rate) and EUR/USD is powerful as Figure 4 shows. As the curve has flattened, EUR/USD has tended to weaken. In part that reflects portfolio diversification out of low yielding euro area assets.
Until these key relationships show signs of reversing, EUR/USD is likely to remain under downward pressure. EUR/USD has spent much of this year a 1.05-1.15 trading range, largely because the anticipated timing of US interest rate hikes was frustrated by various events (i.e. Chinese equity market volatility, polar vortex). The level of the dollar has also been a concern for policy makers as it has acted as a drag on net exports and output, especially given weakness in overseas demand.
The recent strength of the dollar is something that the FOMC is cognisant of and how the dollar responds to US interest rate rises will be important for future policy considerations. Certainly the pace of appreciation has slowed which the FOMC may welcome. The response in equity markets to a Fed hike will also be important. History tells us that the dollar does not always initially respond well to US rate increases, so it will be critical to watch how the dollar trades in December in addressing its mediumterm direction throughout 2016.
We have not had a situation before where euro area interest rates are negative and falling and QE is expanding at a time when the Fed hike. For now, equities are holding in and the VIX is well behaved.
In that environment the dollar is continuing to stay firm and we recommend staying core short EUR/USD."
