EURUSD has traded significantly away from interest rate differentials – reason enough to take a deeper dive into what drives the euro. Interest rate differentials define the short-term attractiveness of a currency pair, and since rate differentials are impacted by relative monetary policies, it is the relative cyclical position of economies at least tactically influencing FX rates.
...But what’s been holding the EUR up then? We think two things: first, foreign investors have over the last year decreased FX hedge ratios on EUR-denominated equity investments, putting upward pressure on the common currency. Second, we think there has been diversification of reserves into the EUR over recent months.
While the EU data don’t break down portfolio liabilities by country, the data are provided by Japan’s ministry of finance. These numbers show that earlier this year Asia was buying record amounts of short-term JGBs – suggesting reserve diversification. Given that the largest reserve managers are also underweight EUR reserves, diversification into this direction seems likely too.
Due to these factors, the EUR has been supported higher than fundamentals would suggest, making it more difficult for the ECB to tackle the deflationary threat, in our view. However, such flows are not lasting and once the transitory effect they have on price wanes, the EUR should recouple with yield spreads, we think.
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No Long-term EUR Stability. A combination of the absence of meaningful structural reform able to enhance EMU’s growth potential, ECB policy action failing to support EMU’s bank profitability and the lack of EUR weakness suggests EMU edging closer to a Japan-style outcome.
Does this mean the EUR will go the JPY route and strengthen for two decades? We think not. When Japan went into deflation, it was able to support its lifestyle via its income balance generating income from foreign asset holdings and bringing this income back to Japan. JPY strength was a result of income balance related repatriation flows. EMU has no net foreign asset position. It has a foreign liability position instead.
This means once the EMU financial sector has adjusted its balance sheet ratios to regulatory requirements, you will likely see the EUR coming under structural selling pressure again.
*MS targets EUR/USD at 1.06, 1.03, and 1.0 by the end of Q2, Q3, and Q4 respectively.
