latamen
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
    Multi-Asset Strategist

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.”

Stay informed on our latest insights with monthly mail updates
Stay informed on our latest insights with monthly mail updates
Subscribe

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.”

Logo

Important information

The Robeco Capital Growth Funds have not been registered under the United States Investment Company Act of 1940, as amended, nor or the United States Securities Act of 1933, as amended. None of the shares may be offered or sold, directly or indirectly in the United States or to any U.S. Person (within the meaning of Regulation S promulgated under the Securities Act of 1933, as amended (the “Securities Act”)). Furthermore, Robeco Institutional Asset Management B.V. (Robeco) does not provide investment advisory services, or hold itself out as providing investment advisory services, in the United States or to any U.S. Person (within the meaning of Regulation S promulgated under the Securities Act).

This website is intended for use only by non-U.S. Persons outside of the United States (within the meaning of Regulation S promulgated under the Securities Act who are professional investors, or professional fiduciaries representing such non-U.S. Person investors. By clicking “I Agree” on our website disclaimer and accessing the information on this website, including any subdomain thereof, you are certifying and agreeing to the following: (i) you have read, understood and agree to this disclaimer, (ii) you have informed yourself of any applicable legal restrictions and represent that by accessing the information contained on this website, you are not in violation of, and will not be causing Robeco or any of its affiliated entities or issuers to violate, any applicable laws and, as a result, you are legally authorized to access such information on behalf of yourself and any underlying investment advisory client, (iii) you understand and acknowledge that certain information presented herein relates to securities that have not been registered under the Securities Act, and may be offered or sold only outside the United States and only to, or for the account or benefit of, non-U.S. Persons (within the meaning of Regulation S under the Securities Act), (iv) you are, or are a discretionary investment adviser representing, a non-U.S. Person (within the meaning of Regulation S under the Securities Act) located outside of the United States and (v) you are, or are a discretionary investment adviser representing, a professional non-retail investor. Access to this website has been limited so that it shall not constitute directed selling efforts (as defined in Regulation S under the Securities Act) in the United States and so that it shall not be deemed to constitute Robeco holding itself out generally to the public in the U.S. as an investment adviser. Nothing contained herein constitutes an offer to sell securities or solicitation of an offer to purchase any securities in any jurisdiction. We reserve the right to deny access to any visitor, including, but not limited to, those visitors with IP addresses residing in the United States.

This website has been carefully prepared by Robeco. The information contained in this publication is based upon sources of information believed to be reliable. Robeco is not answerable for the accuracy or completeness of the facts, opinions, expectations and results referred to therein. Whilst every care has been taken in the preparation of this website, we do not accept any responsibility for damage of any kind resulting from incorrect or incomplete information. This website is subject to change without notice. The value of the investments may fluctuate. Past performance is no guarantee of future results. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency. For investment professional use only. Not for use by the general public.

I Disagree