Why the Euro Bear Market is Only Half Over

(on business trip to Europe, updates will be sporadic)

It is precisely because the euro's decline in over-determined that the slide has accelerated.   It is not just that the ECB is buying sovereign bonds.  It is not just that the strength of the US labor market has persuaded more participants that the Fed will lose its "patience" (as in forward guidance) next week.  It is not just the European officials have yet to convince investors that EMU is irreversible.   It is the fact that all three forces are operative. 

These forces have conspired to get rid of the incentives global investors have for holding on to euros.  Using Germany as a proxy, look at what has happened to interest rate differentials.  The US 10-year yield is about 192 bp more than Germany.  This is the widest since the late 1980s.  The premium was only 166 bp at the end of February.   The 2-year premium of 93 bp is an eight year high.   

Moreover, consider the premium relative to German yields.  A 192 bp premium the US offers on 10-year money compares with 20 bp the benchmark 10-year bund now offers.   That is to say that the US yield not just a little larger than Germany, but 10-times more.    At the 2-year part of the curve, one has to pay the German government for the privilege of lending it money.  The US Treasury pays 70 bp to borrow your money.   

Not only does the euro-based investor lock in a significantly higher yield by investing the US, but they also get the dollar exposure as a kicker.  Already this month, the dollar has risen by more than 5% against the euro.  Simply stated, euro-based investors are paid to be long US dollars. Anecdotal reports suggest that some financial institutions in the euro area are promoting dollar deposits for their euro-based clients.  

The weak euro and low interest rates are fueling a surge in US corporates issuing euro-denominated paper.  A year ago, one was paid about 6 bp to swap the euros into dollars (per year) for five years.  Now one is paid nearly 40 bp.   

If the interest rate differential stabilizes here, it is dollar-positive, but here is no compelling reason to think that the interest rate divergence has peaked yet.  The ECB's bond buying program has just begun.  The Federal Reserve has not yet raised rates.  

Even if one makes some conservative assumptions on the trajectory of Fed policy, the Fed funds target range may be 100-125 bp by September 2016, when the ECB's bond buying program may end. The admittedly thinly traded September 2016 Fed funds futures contract implies a yield of 122 bp. These calculations mean that one will be paid to be long dollars against the euro not for months, but quarters, if not years.  

It still does not seem widely appreciated that during the Federal Reserve's long-term asset purchase, foreign investors were more willing to sell their Treasury and Agency securities than domestic investors.  We suspect the same general pattern will be repeated under the ECB's plan. Eurozone banks buy their sovereign bonds as they boost their core capital under the new regulatory regime.   Pension funds and insurance companies may not be eager sellers either as it will be difficult to replace the yield in their portfolios.  

Some speculative foreign investors may have bought European bonds on ideas they will be able to sell them to the European central banks at a higher price.  Other private foreign investors will likely be more eager than EMU-based investors.  The drag from the euro is more than offsetting the capital gains on the bonds.  Foreign central banks who had diversified into euro instruments might look to reduce their exposure.  As Draghi noted at last week's ECB press conference, about half of the euro area bonds are held outside the euro area.  Given the incentives discussed above, we suspect that the foreign sales to the European central banks will lead to an exodus from the euro itself.  

The dollar bull market that is associated with Reagan's first term saw the euro equivalent (it of course did not exist at the time) decline by roughly 57%.  The dollar bull market associated with Clinton presidency saw the euro equivalent (and the actual euro) decline was about 45%.  Given the magnitude of the divergence of monetary policy and its trajectory, if this dollar bull market is going to be line with the magnitude of the two previous bull markets, the euro's decline will see it test the record lows set in 2000 around 82 cents.

We note that both of those earlier dollar bull markets ended only after the central banks coordinated intervention.  This is not to suggest another Plaza Agreement (this year is the 30th anniversary).  Rather it speaks to the power of the bull markets.  Just as the dollar overshot on the downside, the bull market will not be over until the dollar overshoots on the upside.  It strikes us that those who do not think that the euro will fall as far as we suggest have the burden of proof.  They must argue that something will prevent the dollar from rising as far as it has in past multi-year bull markets.