- The euro continues to follow the appreciatory path implied by the recovery in real yield spreads between Germany and the U.S.
- Together with the bullish shift in speculative sentiment, this suggests the currency is priced for ~15% appreciation over the next 3 months.
- With this in mind, we remain bullish on the Invesco CurrencyShares Euro Trust ETF, which tracks the EURUSD currency pair.
The euro continues to follow the appreciatory path implied by the recovery in real yield spreads between Germany and the U.S. Our fair value estimate suggests that EURUSD could be trading as much as 15% higher. With this in mind, we remain bullish on the Invesco CurrencyShares Euro Trust ETF which tracks the EURUSD currency pair. While the euro’s close correlation with the S&P 500 suggests that the FXE will remain driven in part by general risk sentiment in the near term, the ETF offers a low cost to hedge against the potential for the U.S.’s extremely loose monetary and fiscal policy mix to trigger a rapid dollar decline.
Real Yield Spreads Continue To Support The Euro
We turned bullish on the euro back on May 10 (see “FXE: Real Yield Spreads Favor The Euro“) amid what we saw as deeply negative sentiment towards the currency bloc and widespread fears of a dollar shortage. The rapidly improving real interest rate spread between Germany and the U.S., driven largely by the U.S. Fed’s aggressive easing measures, suggested the euro was set for double-digit gains against the dollar.
Spread of Germany Over U.S. 10-Year Inflation-Linked Bond Yields
Since then, we have seen the euro rally ~5%, during which time the fundamental picture in terms of real yield spreads has further improved. As the chart above shows, 10-year inflation-linked bond yields are now only marginally higher in the U.S. relative to Germany, after seeing a precipitous decline. It is this sharp decline in the spread, rather than the absolute level, that continues to support the euro.
Source: Bloomberg, Author’s calculations
Speculators Are Now Net Long, Which Is Short-Term Bullish
Currency speculators have shifted their euro bets to the most bullish in two years after spending the bulk of the past 18 months positioning for weakness. Thanks to a major unwinding of shorts, net non-commercial positioning as a share of open interest now sits at +17%, compared to a 10-year average of -11%. Shifts from bearish to bullish non-commercial positioning have historically led to gains in the euro relative to its fair value. In other words, when non-commercial positions have shifted from bearish to bullish, the euro has tended to outperform what would have been expected by real yield spreads. This is illustrated in the chart below.
Source: Bloomberg, Author’s calculation
Given the lag that has tended to occur between shifts in speculative positioning and changes in the euro relative to real yield spreads, we have created a short-term fair value estimate for the euro, which is shown in the chart below. Despite the euro’s strong rally over the past two months, the combination of improving real yield spreads and the shift in speculative sentiment suggests the currency is priced for ~15% appreciation over the next 3 months.
Source: Bloomberg, CFTC, Author’s calculations
Over a longer time horizon, the importance of bullish speculative positioning diminishes and, in fact, becomes a contrarian indicator, while the importance of real yield spreads in predicting subsequent returns increases. The following chart shows the correlation between the euro’s deviation from the fair value implied by Germany-U.S. real yield spreads and subsequent 12-month changes in the EURUSD exchange rate. The current level of overvaluation has typically been associated with 5-10% gains in the euro over the next year.
Source: Bloomberg, Author’s calculations
Overall, the above charts strongly suggest that the euro’s rally has further to go. We could, of course, see real yield spreads shift in the dollar’s favor, particularly if the soaring U.S. stock market triggers a rise in the appetite for tapering off recent aggressive stimulus measures. However, we see limited upside for real bond yields in the U.S. and think real yields in both countries will remain deeply negative. This suggests that the EURUSD should move higher to catch up with the improvement in real yield spreads.
The euro is likely to remain closely correlated with risk sentiment in the near term, which is driving dollar moves more broadly. However, we see the FXE as a low-cost way to position for dollar weakness as inflation pressures build as a result of the extremely loose monetary and fiscal policy mix.