The EUR, like global yields, have confounded most macro participants for most of the past several quarters. As the chart below shows, consensus expectations have been for depreciation in EURUSD since last May, even as the cross has rallied 10 full figures:
The consensus view has been something like this:
- ECB is in easing mode while the Fed is looking at when to hike, so interest rate differentials are likely to move against EURUSD
- The US is growing faster than the EU so portfolio flows are likely to flow out of the EU and into the US
- The EUR is rich vs PPP metrics while the USD is cheap
- The US trade deficit is likely to improve as a result of the US energy output while the EU trade surplus is already very high and likely to come down
What actually happened was:
- The relationship between spot and interest rate differentials have completely broken down
- Portfolio flows have been flowing quite strongly INTO Europe
- Valuation differentials are not extreme enough to warrant much attention
- While the US trade deficit has improved, so has the European trade surplus, lead by Germany
Most of the discussion around the cross in recent days revolves around the estimated effects of the different ways that the ECB could ease policy. But that may be the wrong thing to focus on. Interest rate differentials remain uncorrelated to spot moves, and have been since Eonia (the effective ECB rate) hit zero in mid 2012. (Chart below. 5y nominal rate diffs are in purple, real rate diffs in orange) So it is hard to see that changing until overnight rates are ready to move higher. And given Eurodollar market pricing, that may not be for another year.
The decline in importance of rate differentials means that non-carry flows become more important by default. And the picture there looks unlikely to change in the near future. With credit still tight in Europe, and relatively easy in the US, capital flows continue to flow eastward across the Atlantic, as US investors try to earn excess returns by stepping into lending function vacated by European banks. And with periphery debt spreads still offering juicy carry, those flows are unlikely to slow much. Outside of portfolio flows, trade flows continue to flow towards the EMU, powered by German exports to the likes of the US, UK, China and Switzerland. Now, one could think that with the trade weighted Euro up 10% from the 2012 lows, the EU trade balance would be slowing, but if anything, the reverse has been happening. It appears that global growth and technological competitiveness have superceded the effects of a pricier currency, as the trade balance has actually continued to improve.
This all paints a picture that suggests that the longer term trend looks likely to continue. Unfortunately, that is not a good sign for European inflation.
Separately, this was a great FT article on the EU crisis, Merkel and especially the ECB.
- US Housing Starts jumped 13.2% in Apr. The jump was predominantly due to the multifamily sector, which was up 40%.
- U Michigan Confidence declined to 81.8 vs 84.5 exp and 84.1 prev
- India’s BJP party won more than half of the total seats in the lower house in the general election and won a mandate for the next 5 years. This is the largest majority for a single party in 30 years. Voter turnout, at 66%, was a record high.
- Goldman’s Advanced GLI for May has moved into ‘Expansion’ territory
- Mon: RBA Minutes
- Tue: UK CPI, Japan Trade Balance
- Wed: BoE Minutes, UK Retail Sales, Dudley Speaks, Yellen Speaks, Fed Minutes, EU Consumer Confidence, Japan PMI, China HSBC PMI
- Thu: EU PMI, UK GDP, Turkey CBRT, Canada Retail Sales, US Jobless Claims, Existing Home Sales, South Africa SARB
- Fri: German IFO, CanadaCPI, US New Home Sales