March 13, 2017, Dr. Christian Witt (YCAP Asset Management)
Some months ago, markets seemed convinced the USD would continue to appreciate against the EUR. The dollar’s parity with the common currency appeared to be just a moment away. Against all such speculations, the EUR held steady above a key technical resistance level (see Figure 1) and even appreciated a bit. So, does this mean the USD party has been cancelled or just postponed?
Let’s have a look at the current economic and financial set-up. One of the most popular economic determinants of exchange rates is the relative evolution of the current account balances. As Figure 2 shows, the Euro Area has a current account surplus of +3.2% of GDP while the US runs a current account deficit of -2.6% of GDP. Unlike the US, the Euro Area has also gradually improved its current account balance since the end of the Great Recession in 2009. The gap between the two countries’ current account balances has accordingly ballooned to 5.8% of GDP––one of the highest levels recorded since the formation of the Euro Area. Against this background, the USD should depreciate. On one hand, spend-thrift US consumers bid up the EUR to purchase European products. On the other hand, euro zone exporters demand euros since they need to repatriate their US dollars earnings. As even President Trump will need time to implement protectionist policies, the gap will most likely persist for some time to come.
Another factor––derived from the theory of relative purchasing power parity (RPPP)––is the inflation differential between both territories. This approach is based on the idea that inflation deteriorates purchasing power. Thus, the exchange rate of a country with a comparatively high inflation rate should depreciate. The expected depreciation should approximately equal the difference between the inflation rates in the two countries. With US inflation (+2.5% yoy) currently above Euro Area inflation (+2.0% yoy), the USD should decrease by -0.5% per year (see Figure 3).
As we have seen, both economic forces are in favor of a USD depreciation. However, a weakness both arguments share is they solely focus on an exchange rate adjustment via trade. The impact of capital flows is neglected.
We therefore look at financial drivers next. One such measure is real yields (see Figure 4). Today, 10Yr real yields are about -0.1% in the US and -1.8% in the common currency bloc. Thus, it is much more rewarding for global investors to allocate capital to the US. The USD should accordingly appreciate as European investors seek to invest their money across the Atlantic thereby bidding up the dollar. But given their forward-looking nature, investors will also take into account the potential path of future monetary policy. As Figures 5 and 6 illustrate investors appear to have well anticipated that the FED is about to raise rates this month. But the same cannot be said about the ECB whose next steps are uncertain because rapidly accelerating inflation could make investors doubt its commitment to loose monetary policy. As a result, the upward pressure on the dollar might be somewhat mitigated.
However, exchange rates could ‘overshoot’ in the short-term, if the prices of financial assets (denominated in USD) turn out to be sticky. For, if investors cannot appropriately affect asset prices in the short-term, the real yield differential continues to exist. So, the only variable left to absorb the immediate surge in demand for US assets is a rapid appreciation of the exchange rate beyond the « equilibrium » level.
Another point of interest is severe political risk in the Euro Area (see Figure 7). Since investors are typically risk-averse, they have a substantial interest to place their money in a more stable country outside the Euro Area. Such a flight-to-quality phenomenon might also cause the USD to go up in value. On the other hand, if political uncertainty is overstated, appreciation pressure should recede once investors realize their error. In fact, the latest odds taken from bookmakers (see Figure 8 ) show that Marine Le Pen actually loses ground on front runner and former minister Emmanuel Macron.
Taken together, financial factors suggest a USD appreciation while the opposite is true for economic forces. So, which factors are more important? Time to introduce the concept of capital mobility. If capital mobility is high (low), the exchange rate adjustment should primarily progress through capital flows (trade), i.e. investors transferring money (consumers demanding products). Since both the USA and the Euro Area are obviously countries with a very high capital mobility, financial factors should prevail over economic ones in the near term. Hence, the dollar may initially rally, notably driven by the real interest rate differential. However, the euro may take a delayed revenge on the back of stronger economic factors.
Figure 1: USD/EUR Exchange Rate and Key Technical Resistance Level
Figure 2: Current Account Balances for the Euro Area (blue) and the USA (yellow)
Figure 3: Inflation in the Euro Area (blue) and the USA (yellow)
Figure 4: 10Yr Real Yields in the Euro Area (blue) and the USA (yellow)
Figure 5: Probability of a FED Rate Hike in March 2017:
Figure 6: Historical FED Funds Futures Yield Curve
Figure 7: Political Uncertainty in the Euro Area (blue) and the USA (yellow):
Figure 8: Probability of Success For French Presidential Election: Macron (blue) and Le Pen (yellow):
Published on Riskelia’s Blog