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Unlocking value in the euro

Unlocking value in the euro

07-07-2020 | Monthly outlook
An EU stimulus program to recover from Covid-19 may be the catalyst for the euro to rise again, say Robeco’s multi-asset specialists.
  • Jeroen Blokland
    Jeroen
    Blokland
    Portfolio Manager
  • Peter van der Welle
    Peter
    van der Welle
    Strategist Global Macro team, Robeco

Speed read

  • EU plans EUR 750 billion ‘Next Generation’ recovery fund
  • Stimulus package may be the catalyst for euro strength
  • US economy faces bigger challenges in emerging from crisis

The EUR 750 billion package backed by European Commission bonds to help economies battered by the lockdowns could usher in greater fiscal integration, they say.

The biggest potential for resurgent euro strength may be against the US dollar, due to the weaker economic prospects across the Atlantic. This has prompted the multi-asset team to go long on the euro against the greenback.

“United by a common ‘enemy’, Europe is joining forces to recover from the Covid-19 economic fallout,” says strategist Peter van der Welle. “In doing so, it has likely triggered a catalyst to unlock the value in the common currency – the prospect of fiscal integration.”

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Showing new vigor

“On 18 May, the Franco-German axis showed new vigor with a proposal for a EUR 750 billion ’Next Generation EU’ recovery fund. A key element is that the European Commission will issue bonds on behalf of the EU to finance the recovery packages.”

“This will deliver non-negligible savings for EU countries that otherwise would have to pay higher yields on their lower-rated sovereign bonds compared to AAA-rated EU paper. Although it may not encompass genuine debt mutualization, it is nonetheless a promising step to further fiscal integration within the EU, and could be marked as ‘historic’ further down the road.”

“The announcement of the new recovery instrument fund seems to have been a catalyst for recent euro appreciation. The announcement coincided with an inflection point in the risk premium in the EUR/USD exchange rate, with market participants starting to demand a lower risk premium for having euro foreign currency exposure.”

Overshoots in the premium

The euro risk premium is defined as the part the of the EUR/USD exchange rate that is not explained by the 2-year interest rate differential between the US and Eurozone (see chart). “Swings in the euro risk premium can be sizeable, and they have the tendency to over or undershoot fundamentals over time,” says Van der Welle.
The euro risk premium is the part of the exchange rate unexplained by rate differentials. Source: Refinitiv Datastream, Robeco.

“In our view, the risk premium in the euro did overshoot at the end of March by approximately 10%, based on the 2-year rate differential. Only a catalyst to unlock this value was lacking. With progress being made in the negotiations around the recovery fund, we could be near another major inflection point for the euro risk premium.”

“While there is still debate among EU members, the overarching signal is that Europe may be finally getting its act together, requiring a lower risk premium for holding euro currency exposure.”

Europe versus the US

Meanwhile, the US is emerging from the coronavirus pandemic with more difficulty than Europe, which bodes well for the euro strengthening against the greenback, says Senior Portfolio Manager and Head of Multi-Asset Jeroen Blokland.

“The US is now the epicenter of the coronavirus in the developed world, while Europe is experiencing lower levels of unemployment, has better job protection, and has the advantage that Germany’s key trade links with China are a few months ahead of the US,” he says.

“An outperforming Eurozone manufacturing sector versus the rest of world has historically coincided with a stronger trade-weighted euro.”

Going long on EUR/USD

“We have implemented our positive view on the euro by going long against the US dollar. While we believe a decline in the risk premium will push the euro higher against most currencies, we particularly see upside against the US dollar.”

“The traditional driver of US dollar strength, the short-term interest rate differential between the 2-year government bond yield in the US and Germany, has greatly diminished. Historically, this differential has largely explained changes in the EUR/USD exchange rate.”

Relative attractiveness

“This differential has compressed massively during the last 18 months or so, falling from a historically large 3.50% to less than 0.90% now. This means that the relative attractiveness of the US dollar compared to the euro has declined.”

Another reason for potential dollar weakness is the US government’s budget. “Based on the latest projections, the US budget deficit will be significantly bigger than that of the Eurozone in the coming years (see chart),” Blokland says.

Following its own stimulus, the US now has a much higher budget deficit than the EU. Source: Bloomberg.

Beware the ‘twin deficit’

“In addition, the other major imbalance within the US economy, the trade deficit, may lead to further dollar weakness if investors start to ponder the ‘twin deficit’ again.”

Finally, US dollar weakness would also occur should further fiscal integration in the Eurozone result in the creation of so-called Eurobonds. “As these bonds represent the whole Eurozone, this new asset would likely have a higher yield than German government bonds, further reducing the yield gap with the US,” Blokland says.

“If Eurobonds are issued, a diversification of capital flows over low-risk assets would be possible, supporting the EUR/USD exchange rate.”

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