The euro is not ready for a sell

Posted on 27. May, 2014 by Jean Jacques Ohana in Weekly Focus | Comments Off

The EUR/USD was undoubtedly hit in the aftermath of Draghi’s pledge to react to low inflation and low growth conditions in the Eurozone, dropping from around 1.40 down to 1.3650.

As a matter of fact, Riskelia’ s trend indicator (figure 1) which had been hovering around a significant 60% value since 2013, fell in slight positive territory. Many market participants argue that it is time to sell the euro since it is overvalued and must correct to provide competitiveness to peripheral Eurozone countries (and France).

Meanwhile, the structural reasons for euro’s strength we outlined in 2013 are still at work:

  1. Inflation is structurally lower in the Eurozone than in other developed countries (figure 2). Indeed, the 10 years breakeven inflation rate in Germany hardly reaches 1.34%. Such an anticipated inflation rate is staggeringly low, given the need for other Eurozone countries to adjust their relative competitiveness compared to Germany. As showed in figure 3, the EUR BIS effective exchange rate is not presently overvalued because of this low relative inflation. Let us remind that the major long term driver of exchange rates is the inflation rates differentials.

     

  2. Current account balance (figure 4) has continuously improved in the Eurozone as global internal devaluation policies have destroyed domestic demand and lowered the PPI (cost of production).

     

  3. The euro is not any more a risky currency. As showed in figure 5, the EUR/USD is presently negatively related to equities downside. It means that the euro is serving as a repatriation currency in case of financial turbulence. Should the ECB lowers interest rates even more, the euro would officially stand among the funding currencies (together with Japanese yen and Swiss franc), formalizing its new safe haven status. Therefore, selling the euro is not anymore beneficial to a “risk on” portfolio as it magnifies portfolio’s risk in case of risky assets’ correction.

The only plausible scenario which would cause the euro’s fall would be a political crisis in the euro zone. In this scenario, the fear of a breakup would undermine confidence in the viability of Eurozone and weigh in the euro.

As implied volatility of the euro is standing at a record low (figure 6) and the indecisive ECB has placed itself in a position where it is more likely to disappoint, the euro may again surprise by its resilience.

Figure 1: Riskelia’s trend indicator on EUR/USD

Figure 2: Breakeven inflation rates in countries of the Eurozone

Figure 3: Euro real effective exchange rate


Figure 4: Eurozone Current Account in % of GDP

Figure 5: Correlation of EUR/USD to a global basket of equities conditional on downside equities performance. The EUR/USD is presently negatively correlated to equities.

Figure 6: 3 month implied volatility of EUR/USD


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