Thoughts on Euro's Continued Resilience

The euro has slipped about 1.0% against the dollar in the first half of January.  Yet, given the divergence of growth and monetary policy, many investors and observers remain puzzled by the euro's resilience at this late stage.  

One can begin with the view the market is being irrational, but that would make any analysis superfluous.   A more productive strategy is to assume the markets are being rational and seek to understand the logic.  

First, let's examine the assumptions.  Growth differentials do not seem to be key on their own in explaining or forecasting currency movement.   They need to be reflected in profitability or interest rate differentials.  While there seems to be a divergence in the trajectory of monetary policy between the US and Europe,  it is still mostly in rhetoric.  

The Federal Reserve has convinced the market that there is a difference between tapering and tightening.   There are many ways to illustrate this.  Consider, for example, that the implied yield on the December 2014 Eurodollar futures is 35 bp now.  That is half of what it was in early September, when many thought the Fed was going to taper.   Similarly, the US 2-year yield is now just below 38 bp/  In early September is was around 50 bp.   This is to say that the Fed's tapering and the stronger growth profile has not translated into higher US interest rates.  

The divergence with Europe has not translated into wider interest rate differentials.  The US-German 2-year interest rate differential remains a trading range that has largely prevailed for the past two years.  At the low end the US premium dips to around 6 or 7 bp, while it the high end, it can edge a little above 20 bp.  The stability of the spread, regardless of the trajectory of growth or monetary policy is demonstrated by noting that the 100 and 200-day moving averages have converged between 15-17 bp 

Even for the nearer-term borrowings the US premium is not what one would expect, given the macro fundamentals.  The spread between the December 2014 Eurodollar and Euribor implies about a 7 bp US premium.  It peaked six months ago near 30 bp. 

It is not just that US rates at the short-end have slipped, but Germany/Europe's have risen.  In fact, the US 2-year yield  has risen about 6 bp over the past six months.  Germany's 2-year yield has risen 9.5 bp.

In part,  this reflects perceptions that there is less need for Germany's safe haven.  Non-residents investors are  feeling more comfortable in Spain and Italy's asset markets.    In addition, there has been a tightening of financial conditions in EMU as defined by the ECB's balance sheet and excess liquidity.  The combination of paying down the LTRO borrowing and some what lower borrowings from the main repo operations have seen the excess liquidity in the Euro system fall to almost 130 bln euros.  This is the lowest level since December 2011.

The continued fall in excessive liquidity is contributing to the EONIA's rise and increased volatility.  From the middle of 2012 through the middle of last year, the US effective Fed funds rate was above EONIA.  Beginning in the middle of December EONIA has been generally above the effect Fed funds rate.   The EONIA premium over the effective Fed funds rate was 14 bp yesterday.  

One can still be paid to be long euros for very short-dated transactions.  A few months ago this was not the case.  The point is not that it is a big pick up in yield, but rather one no longer has to pay to be long euros.  

Turning to the central banks' balance sheets, the Fed's tapering does not mean that its balance sheet has peaked.  Far from it.  The Feds' balance sheet won't peak until its stops buying Treasuries and Agencies altogether.  That means that balance sheet  is going to continue to grow until late Q3 or early Q4.    The Fed argues that its easing lies with the stock of asset holdings (the size of its balance sheet).  In contrast, many in the market think the easing has more to do with flows or the weekly purchases.   

The ECB's balance sheet is shrinking.  While the ECB says that it has many policy tools at its disposal, it does not seem to be in a particular hurry to use them.  Neither the volatility of EONIA, the reduction of excess liquidity, the nearly 2-years of contracting loans to households and business, the slugging growth of money supply nor the disinflation has prompted new balance sheet expansion strategies.  

Comments today by the ECB's Coeure seemed to play down the likelihood of an near-term action, suggesting that as growth recovers in the EMU, there is less a need for new long-term loans.    Of course, he still paid lip service to the idea that the deposit rate cut be cut below zero "if needed."   

This is surely not meant to be an exhaustive discussion.  There are other factors that should be  considered as well.  We were though struck the financial variables, which seem counter-intuitive to the idea of Fed tapering and what appears to be an acceleration of US growth.