25 Mar 2018
The euro’s upward march against the US dollar has been on hiatus since the end of January. How do the arguments for the two currencies stack up, and where might they go from here?
Signs have begun to appear of a divergence in data momentum in the US and European economies. In the US, data remains robust: inflation is picking up, GDP expectations are trending higher and credit standards appear to be tightening. However, there are some structural weaknesses in the economy, particularly the twin deficit (fiscal and current account) as a result of recent tax reform and the two-year budget deal. In Europe, while structural fundamentals remain strong, macro data has begun to soften. Eurozone inflation is still considerably lower than long-term targets, and growth momentum has shown signs of slowing as private consumption has softened amid flat domestic demand. However, this loss of momentum should be considered in the context of extraordinary growth, with eurozone GDP for Q118 tracking around 2.5% year-on-year—meaningfully above trend.
Europe’s slight edge over the US on a macro level suggests that the euro should outperform the US dollar, and this is what we saw over the course of 2017, with the euro appreciating by more than 14% vs. the US currency. The trend continued at the start of this year, with the euro/dollar exchange rate (EURUSD) climbing 3% throughout January to a peak of 1.25. However, the euro has since traded in a relatively tight range vs. the US dollar, and has even depreciated slightly. Yield differentials between the two markets go some way to explaining this pause, as higher rates in the US may be acting as an anchor on a higher EURUSD. Monetary policy expectations for the two economic areas may also be playing a role, with markets pricing in almost three rate hikes this year from the Federal Reserve against nothing significant from the European Central Bank (ECB). A change in stance from the ECB would be likely to have an effect on the exchange rate between the two currencies and could break the deadlock.
Higher yields in the US may be acting as an anchor to EURUSD
Source: Bloomberg, J.P. Morgan Asset Management; data as of 14 March 2018.
Investor positioning has turned in favour of the euro over the US dollar over the past few months. Our proprietary positioning survey shows euro positioning near its recent highs and dollar positioning the shortest of the G10 currencies, suggesting the euro might be being viewed as an attractive safe haven currency given uncertainty surrounding Brexit and signs of increasing US protectionism. This might prove a headwind to further upward moves in EURUSD, although there is still room for positioning to diverge further considering historical long/short positions across the two currencies.
A strong case can be made for both currencies, although on balance it is surprising that euro’s upward move has recently lost momentum. Whatever the underlying reason, the disconnect could have implications for the bond markets. If the euro remains weak, contributing to easy financial conditions, it would give the ECB more latitude to raise rates—and hence pose further risks to European bonds. All in all, over the course of this year we expect the twin deficit argument to win out, causing EURUSD to move higher, towards 1.30. Either way, investors will need to keep an eye on this contest and be prepared for the potential effects on European bonds.
Each week J.P. Morgan Asset Management’s Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Click here to read more about our FQT capabilities.
NOT FOR RETAIL DISTRIBUTION: This communication has been prepared exclusively for institutional, wholesale, professional clients and qualified investors only, as defined by local laws and regulations.
The views contained herein are not to be taken as advice or a recommendation to buy or sell any investment in any jurisdiction, nor is it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit and accounting implications and determine, together with their own professional advisers, if any investment mentioned herein is believed to be suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yield are not a reliable indicator of current and future results.
J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. This communication is issued in the United Kingdom by JPMorgan Asset Management (UK) Limited, which is authorized and regulated by the Financial Conduct Authority.