Why is the euro starting to trend lower?

Posted on 22. Jul, 2014 by Jean Jacques Ohana in Weekly Focus | Comments Off

We have anticipated the euro’s strength for more than a year against the consensus.

The main forces behind the euro’s strength are still at work:

  • Current account in the Eurozone is still progressing due to uncooperative and simultaneous policies of competitiveness. The Eurozone current account is nearing 3% of GDP, implying recurrent repatriation of foreign currencies by Eurozone exporter.
  • Inflation remains subdued in the Eurozone, flirting with deflation levels. Low inflation compared to Eurozone’s trading partners carries the future increase in the single currency due to improved competitiveness.

Meanwhile, Riskelia’s trend is turning negative on several European currencies as showed in figure 1. The decrease of the SEK, due to the easing of the Swedish Riksbank to fight outright deflation, is leading European currencies lower. Trends on the EUR, the CHF and the NOK have melted afterwards (becoming slightly negative), translating a global improvement of the dollar vs. all European currencies bar the GBP. The trends displayed in figure 1 illustrate a sharp contrast of behaviors within European currencies at work since 2013.

We think that the most important factor behind the euro’s current weakness is the decrease of long term rates towards null in almost every country in the Eurozone. Even though real rates remain absurdly elevated in euro peripheral countries, the long term real rate (as reflected by Euro MTS average yield and inflation swap rate) converged at last towards the dollar real rate (figure 2). As the economic outlook deteriorates in the Eurozone this trend is likely to persist, compared to the US in relative better shape although the Federal Reserve has pledged to remain accommodative as long as possible.

In figure 3, we show that the EUR/USD is no longer a risky currency connected to equities or cyclical commodities. The only market left connected to EUR/USD is the gold. As real rates in the euro zone trend lower, it makes sense to play the euro’s downside vs. Gold as the ECB may be forced to commit to a genuine quantitative easing to fight against deflation.

Figure 1: Riskelia’s trend indicator on various European currencies vs. the dollar

Figure 2: Euro zone vs. US 10 years real rate based on treasury rates (Euro MTS and T Notes) and inflation swap rates

Figure 3: One year rolling correlation of EUR/USD vs. main markets

Figure 4: Riskelia’s trend indicator on the Gold vs. EUR

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