The divergence between the Eurozone and the US is growing. And I’m not just talking about the difference in bond yields. Significant gaps have also developed between equity markets and GDP growth numbers. And, yet, the EUR/USD exchange rate is nowhere near a new low. So what’s the deal?
The movement of exchange rates depends, for a large part, on short-term interest rate differentials. The chart above shows the difference between 2-year bond yields in the Eurozone and the US, plotted against the EUR/USD exchange rate. The black line shows that the gap between short-term rates has grown to an unprecedented 3.40%. In theory, this means that US bonds are becoming more attractive for investors. But as these investors push up demand for US dollars, the EUR/USD exchange rate rises as well, resulting in a new equilibrium between bond yields and currency rates. However, as the blue line shows, the EUR/USD is still around 1.15, far from its low set in December of 2016, while the yield gap has continued to grow.
Growth is moving in the same direction. The US economy grew at an annualized pace of more than 4% in the second quarter, and it may have done so again in the third quarter. The Eurozone economy, on the other hand, grew at an annualized rate of 2% in Q2, and probably around the same in Q3. Historically, differences in GDP growth are also reflected in the exchange rate – in this case, again favoring the US dollar above the euro.
So why hasn’t the euro declined more lately? Expectations about future monetary policy is one important reason. The Federal Reserve has hiked rates eight times since late 2015 and is actively reducing its balance sheet. While investors differ on the number of hikes still to come, they agree that we are nearing the later stages of the hiking cycle. The ECB, however, has yet to start normalizing its monetary policy. But, if we look two years head, for example, the ECB may well be tightening more on a relative basis, even though it will be starting from extremely accommodative levels.
A second argument is that investors are already heavily invested in the US dollar. In recent months, the so-called ‘net speculative positioning’ in the US dollar has increased significantly. They aren’t many investors left that believe the EUR/USD exchange rate could go up. Theoretically, when all investors make the same trade, there is no one around to make it profitable. Obviously, it’s not that extreme in this case, but positioning is skewed.
Euro is cheap
Finally, the euro is undervalued. The chart below shows the value of the G10 currencies against the USD based on data provided by the OECD. The euro is the most undervalued currency within the group. There are many tools for determining the relative value of a currency, such as the famous Big Mac Index or producer prices, but all of them draw the same conclusion: the euro is cheap. While valuation seldom triggers a major currency movement, it does act as a catalyst once one gets underway. For example, any reduction in the political tensions between Italy and the European Union is likely to push the euro higher, in which case valuation becomes a helpful companion in driving up prices. In any event, our base case is that we will not see parity in the EUR/USD exchange rate any time soon.