There’s been a seismic shift in the euro’s fortune.
Money managers are the most optimistic they’ve ever been on prospects for the common currency after its best month in almost a decade. And demand for European assets is so high that the currency is within a whisker of being more expensive than the dollar for the first time since funding pressures jumped earlier this year.
That’s because the European Union’s landmark rescue fund has gone a long way in soothing concerns over the bloc’s structural risks, and efforts to control the coronavirus and reignite the economy look particularly promising compared to the U.S. Those factors are setting the stage for a long-lasting change for the euro.
“This is not a matter of growth this year or next year or predictions about the cycle — it’s really something more structural,” said Nicolas Veron, a senior fellow at the Peterson Institute for International Economics. “The budget deal changes the way financial markets look at the euro zonein a significant way,” he said, adding that “it’s a big reinforcement of the EU and of the euro.”
Such is the euphoria over the turn in the euro’s paradigm that stocks, which typically see demand fall as their underlying currency strengthens, are rising as traders capitalize on growth differentials between Europe and the U.S. And the rates on some of the highest-yielding sovereign bonds in the 27-member bloc have plummeted to pre-lockdown levels.
The Big Shift
Underpinning the euro’s transformed fortunes is the EU’s landmark €750 billion ($882 billion) package. The deal, thrashed out in July to support the economic recovery, succeeded where years of political wrangling had failed. The rescue fund, which will be financed by the sale of joint bonds, has helped calm fears of a breakup.
Coupled with European Central Bank’s quantitative easing programs, the difference in yield between benchmark Italian and German bonds, a measure of risk in Europe that soared in March, is now the lowest since February.
“It’s a powerful story for the euro,” said Tony Small, head of European interest rate strategy at Morgan Stanley. “A big portion of the tail associated with a euro break-up will likely be perceived to have gone away, and will be replaced by an attractive high quality issuer, which will pull up the entire credit quality of the euro.”
The euro’s 4.8% jump in July sent the currency flying through a bearish trend line that capped gains since 2008, unlocking its potential for more rallies. It also spurred a rush among analysts to revise their forecasts higher.
And while the currency has taken a breather in the spot market in August — rising 0.2% to $1.1799 on Tuesday—net-long positions in the security rose to an all-time high, according to CFTC data.
Beating the dollar
The currency’s fundamentals look especially strong when compared with the dollar, which has seen net-short positions versus major peers rise to the highest since 2012, according to Bloomberg calculations of CFTC data.
A gauge for the greenback suffered its worst July since 2010, ending the month near the lowest level in almost two years. It’s being weighed down by the rising number of infections in the U.S., which exceeded 5 million, the nation’s fragmented response to the virus, a Washington standoffover a new economic relief bill, and what may be a contentious presidential election in November.
These risks play in the euro’s favor.
There are signs the euro area has succeeded in breaking the link between economies re-opening and the virus escalating, helping to boost forecasts for growth. Even though Europe’s lockdown and initial downturn were larger, gross domestic product is poised to expand 5.5% in 2021, about 1.5 percentage points faster than the U.S., according to estimates compiled by Bloomberg.
That’s only happened eight times since 1992, according to International Monetary Fund data.
Real Yields
Nonetheless, there are mounting concerns about new flare-ups in infections in Europe. The number of confirmed cases in Germany, the continent’s biggest economy, rose more than 6,000 in the seven days through Sunday, the most since May, according to data collected by Johns Hopkins University and Bloomberg News.
“The risks remain that new outbreaks will occur, particularly as we get into winter,” said Iain Begg, a research fellow at the European Institute of the London School of Economics. “But the range of policies—both the economic and containment policies in Europe—seems to me to be better-attuned to dealing with both the health crisis and the economic crisis than the U.S.”
With real yields in the U.S. at a record low and falling faster than elsewhere, investments are flowing back into Europe where the government response to the virus is more predictable, said London-based Jordan Rochester, a Group-of-10 foreign-exchange analyst at Nomura International.
Until those dynamics change or there’s a second wave, Kenneth Broux, a strategist at Societe Generale SA in London, recommends buying dips in the euro in the medium term.
“It’s not just growth,” said Peter Chatwell, head of multi-asset strategy at Mizuho International Plc, who sees the currency rising to $1.30 by July 2021. “It’s also that politically, the euro has never been as strong as this, and it’s never been as close to being properly constructed as this.”
