Currencies: Euro rally pauses but has legs
Everyone seems to love the euro, so much so that it may have become a crowded trade. In the near term, too much optimism could dampen the rally. However, the likely tapering of bond purchases by the European Central Bank in 2018 and the revival of centrist governments will support the euro in the medium term.
After trading within a range between 1.04 to 1.15 over the last 30 months, EUR/USD broke out higher after the July ECB meeting. While ECB President Mario Draghi reiterated the determination to provide the monetary accommodation necessary to get to 2% inflation, he also expressed more confidence in the economic outlook. This suggests that the ECB is thinking about tapering its quantitative easing program next year. Valuation is favorable for the euro, and in our view, does not stand in the way of a continued strengthening. The euro is still around 10%, which is cheap relative to its purchasing-power-parity level versus the U.S. dollar, as the chart below shows.
EUR/USD: purchasing power parity (PPP)
Source: Thomson Reuters Datastream, as of September 12, 2017.
The single European currency is also cyclically attractive. Economic growth in the eurozone is very strong, as purchasing manager indices around the region linger near record highs and decouple from the rest of the world. Political risk has faded with euro-friendly outcomes in the Dutch and French elections earlier this year. Uncertainty around the next Italian general election in 2018 still looms, but probably won’t heavily influence the euro until early 2018. Meanwhile, the German federal election on September 24, should provide stability in the eurozone’s largest economy, according to German election polls in mid-September showing Chancellor Angela Merkel set to retain her grip on power for a fourth successive term. While the euro has been the big winner in currency markets this year, the U.S. dollar is the mirror image of that strength. After enjoying a buoyant three-year period through the end of 2016, the U.S. Dollar Index has now dropped to the lowest level since January 2015. We can blame tensions between North Korea and the United States for the most recent bout of weakness, as well as the delayed delivery on President Trump’s campaign promises on tax cuts so far. Coupled with the expensive valuation of the greenback, which is still above its historical average in inflation-adjusted terms, investors were all too happy to reduce their dollar holdings this year.
From a cycle perspective, within our cycle, value and sentiment (CVS) investment decision-making process, the U.S. dollar maintains a significant interest rate advantage over most other developed nations, which should be a tailwind. However, U.S. economic data has been less uniformly robust, particularly compared to the eurozone. As for sentiment, the U.S. dollar looks oversold so we believe a short-term technical recovery is possible. Reported speculative positions in currency futures suggest that short U.S. dollar may have become a crowded trade. However, the longer-term trends and fundamental forces are now in the euro’s favor.
Other major currencies
- UK pound sterling (GBP)
The pound was stronger against the U.S. dollar last quarter as GBP/USD reached a year-to-date 2017 high of 1.33 after higher-than-expected inflation figures. We are skeptical as to whether the upward price pressures will be sustained. In our view, the post-Brexit economic growth slowdown is already becoming apparent, which, together with the fading impact of sterling weakness, should lead to softer inflation numbers towards the end of this year. As uncertainty surrounding the Brexit negotiations lingers and the Bank of England probably holds steady on interest rates, we think the upside for sterling is now limited.
- Japanese yen (JPY)
The Bank of Japan (BoJ) arguably runs the loosest policy among the world’s major central banks. It has adopted a yield curve control framework whereby the BoJ buys as many bonds as is necessary to keep the yield on 10-year Japanese government securities at 0%. Changes in U.S. bond yields disproportionately impact the yen because Japanese yields are pegged this way. We expect U.S. yields to rise modestly, which is a headwind for the yen.