We have long argued that, with a number of major central banks reaching a lower bound for nominal policy rates, real rates should become key for G10 FX. This is because at the lower bound, non-conventional policies increasingly work through inflation expectations. When nominal rates have little room to move, market reaction to central bank policy action should be mainly captured through inflation expectations and their impact on real rates.
Real rates spreads are currently sending a bullish signal for EURUSD (Chart 1). Drilling into the details of what moved the eurozone-US 2y real rate spread suggests that, while both eurozone and US real rates declined recently, US rates fell by nearly twice as much as eurozone rates. As highlighted in Chart 2, US real rates fell because a 70bp rise in US inflation expectations from mid-February far outpaced the 13bp rise in 2y yields. Meanwhile, eurozone inflation expectations rose by a smaller 35bp and nominal yields were little changed.
In our view, real rate dynamics capture well the market impact of recent central bank policy announcements. Markets went into the March ECB meeting with a rate cut priced in and came out with the perception that the ECB has reached the lower bound for the deposit rate. Subsequently, the eurozone 2y yield is not far from where it was nearly two months ago. At the same time, the ECB still has a hard time raising domestic inflation expectations, which remain stuck below levels that prevailed around the start of the ECB’s quantitative easing programme in 2015, as measured by shorter-term measures such as the 2y inflation swap as well as the longer-term 5y5y measure, which is the ECB’s preferred gauge.
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...Where to from here? Already at a lower bound for policy rates, and with only limited scope to increase the size of its asset purchase programme, the ECB may struggle to push real rates down by much, at least in the near term. At the same time, we don’t believe the risk environment will be positive enough in Q2 to allow the Fed to hike, implying that US front-end yields will remain at current low levels.
This should keep EURUSD gradually rising towards our 1.16 target. In the second half of the year we expect a modest decline in EURUSD to 1.14, as a better risk environment gradually allows for a more efficient recycling of the eurozone current account surplus.