- We are long the FXE Invesco CurrencyShares Euro Trust ETF which tracks the EURUSD exchange rate due to the narrowing of the real yield differential between Germany and the U.S.
- Based on historical trends, the euro could be set to rally ~20% over the next two years given the rapid improvement in real yield spreads.
- The recent rise in net non-commercial long positioning has tended to be a leading indicator of euro strength.
- Superior fiscal and external positions in the eurozone, as well as a stronger manufacturing sector, make the bloc arguably better equipped to handle currency strength relative to the U.S.
It’s difficult to be bullish the euro given the currency bloc’s economic, political, demographic, and social stagnation, but it is important to remember that currency trading is a relative game. We do not know of a single economist, strategist, or investment manager who is genuinely positive on the prospects for eurozone growth, while there are still some who believe that the U.S. will recover strongly from the Covid-19 recession. Our argument is simply that the U.S. outlook is deteriorating faster, relative to consensus expectations, than that of the eurozone, which makes us more bearish on the dollar and therefore we expect to see a modest euro recovery. We are long the Invesco CurrencyShares Euro Trust ETF (NYSEARCA:FXE) which tracks the EURUSD exchange rate.
Real Interest Rate Spreads Increasingly Euro-Positive
Real interest rate changes drive currency performance in the near term while the absolute level of real interest rates drives total return performance over the long term (see ‘ FX: The Importance of Real Interest Rates‘). With this in mind, the fact that German 10-year inflation linked bonds are trading ~55bps below their U.S. counterparts suggests long-term euro underperformance. However, the fact that the spread has closed by ~80bps since the start of the year and ~180bps since the peak in 2018 suggests the euro could be in for a rally in the meantime. The real yield spread between the two countries is now back to 2014 levels when the FXE was trading almost 30% above current levels. The narrowing of real yield spreads reflects to a large extent the relative decline in the U.S. economic outlook relative to the eurozone in our view.
The following chart shows the correlation between the euro and the spread of German over U.S. 10-year inflation-linked bond yields. We can use this to calculate the fair value for the euro based on real yield spreads, which currently works out to be around 1.25, a full 15% above current levels. We can also see how previous divergences between the euro and real yield spreads have played out. The following chart shows the close correlation between the euro’s deviation from its fair value and subsequent returns in the euro over the next two years. Based on historical trends, the euro could be set to rally ~20% over the next two years.
Source: Bloomberg, author’s calculations
Further supportive evidence of potential euro strength comes from the recent shift in net speculative positioning. Divergences between the euro and its fair value tend to be driven by shifts in speculative sentiment towards the currency as the chart below shows. Shifts from bearish to bull net non-commercial positioning have tended to lead shifts in the level of the euro relative to its fair value as implied by real yield spreads by around two months.
Source: Bloomberg, CFTC, author’s calculations
We can combine real yield spreads with net non-commercial positioning to get a short-term leading indicator for the euro. The chart below shows that the combination of real yield spreads and speculative positioning suggests the euro should rally to around 1.30 over the next two months. This is not a forecast but it cannot be ruled out given the fact that there’s been a 0.81 R-squared between the euro and this leading indicator over the past 13 years.
Source: Bloomberg, author’s calculations
Could The Eurozone’s Economic Fundamentals Really Support A Stronger Euro?
Writing this article it became clear to us that USD1.30/EUR seemed like an outrageous figure to even suggest given the prevailing negative sentiment towards the eurozone economy. However, we hesitate to say that the currency bloc arguably has stronger economic fundamentals than the U.S., despite its underperformance in terms of real GDP growth over recent years. In 2019, for example, not only did the eurozone have much stronger external and fiscal positions, but also a stronger manufacturing sector and higher national savings per capita.
External Position: The eurozone runs a near-record current account surplus while the U.S. continues to run a sizeable deficit. The spread between the two is now a near-record 5% of GDP. As a result of several years of current account surpluses in the eurozone and deficits in the U.S. the former is now running a balanced net international investment position while the latter is running its largest ever deficit.
Fiscal Position: While the U.S. has been clocking up huge deficits over recent years, the eurozone has managed to narrow its deficits considerably. As a result, we have seen a sharp divergence in government debt levels relative to GDP, with the U.S. figure now 23 percentage points higher than the eurozone.
Manufacturing Sector: While the U.S. economy has grown at a faster pace than the eurozone over the past decade, both countries have seen their manufacturing sectors grow at a similar pace. Despite an inferior per-capita GDP level, the eurozone actually boasts a higher level of manufacturing output per working-age population.
Savings Rates: Closely related to its relative manufacturing strength, the eurozone has a far higher national savings rate than the U.S. The U.S.’ stronger growth rate over the past decade has been entirely down to faster service sector growth which generally does not add to national savings.
It could very well be the case that the dollar is not strong relative to the euro because of the country’s economic strength, but that the U.S. economy has outperformed because of the stronger dollar. Overseas demand for dollars has enabled the U.S. service sector to benefit at the expense of real wealth creation. As explained here, this appears to have created a ‘Dutch disease’ situation where the real economy has become hollowed out and increasingly unable to support a strong dollar.