By Sebastian Petric, RBI
Purposeful European crisis management was key for the recovery of the EUR versus the USD. That being said, optimism with respect to the EUR and the EU crisis response may hit a ceiling from a mid-term perspective. Sebastian Petric, CFA sheds light on this and other crucial drivers of EUR/USD and analyses the cross-effects on CEE.
For the EUR, short-term and long-term factors are aligned with beneficial effects on CEE currencies. One of the key drivers of a higher EUR/USD is risk premia compression in the euro area together with a general improved market sentiment. The ease of the Covid-19 triggered downturn is manufactured by stimuli measures from the European institutions (ECB, Commission) helping capital markets to recover, the EUR to gain ground versus the USD, as well as this adds to the good sentiment towards CEE. The main reason for this is a reduction in structural risks inherent in said institutions. Above-mentioned measures have positive effects on risk and thus, support the recovery of the EUR versus the USD and CEE currencies. The USD, being a risk-off currency, tends to outperform in times of market stress and vice versa. This is the reason for the good performance of the EUR and CEE FX since this March. The bounce in equity prices triggered by global financial support programmes significantly supported the EUR and risky currencies.
One caveat to this is that European economies are still deeply troubled and suffer from the fallout of the coronavirus episode. That being said, the Covid-19 situation in terms of new infections in the US seems to be dire and hence, the euro area is in a better shape from a relative perspective. Moreover, some EUR-problematic sentiment may arise on political issues inside the currency union, as well as with respect to joint fiscal and monetary policy responses in the mid-term.
Another factor which aided the rebound of the EUR is the lower implied interest differential in the EUR/USD exchange rate. One key driver for this was the sharp decline in the benchmark interest rate in the US in March 2020, which also helped risky currencies in CEE. The differential represents the opportunity costs of investing in one or the other currency and hence, lower US interest rates represent a positive factor for the EUR and risky currencies. The same notion holds for the term spread as well. The decline in the US steepness relative to the second moment priced in the German sovereign curve represents a positive for the EUR as the lower US term spread results in a less pronounced pull factor for capital flows. The same logic holds in case yield controls would be introduced in the US.
Regarding long-term fundamental factors supporting the recovery of the EUR/USD exchange rate, there are the purchasing power parity, as well as the current account differential between the euro area and the United States. With respect to the former, the equilibrium concept implies an exchange rate between EUR/USD 1.20 and 1.30. That being said, the concept has a half-life of about three years and thus, we acknowledge that the spot exchange rate only gradually converges towards this fundamental concept. Regarding the current account differential, a negative US current account should be a long-term drag on the USD and the positive current account in the euro area should work in favour of the EUR in the long-run. Nonetheless, any positive fundamental backdrop may be overshadowed by renewed political issues within the euro area concerning fiscal integration and the recent joint fiscal/ monetary responses.
What are the effects of the new EUR/USD spring on CEE? USD strength is like a systematic shock and hence, the recent weakness in the USD is good news for risky currencies in CEE. As mentioned further above, the USD is a risk-off currency and hence, USD weakness correlates with stronger asset prices, as well as CEE currencies. This also goes in line with stronger portfolio flows into CEE. Yield compression in the euro area via lower risk premia leads to increased risk taking and hence, also to better flows into our region. In this environment, CEE currencies tend to perform well versus the USD, but also profit versus the EUR.
Thus, the recent USD weakness has global repercussions and not only benefits the recovery of EUR/USD. There are various factors at play as described in this blog post. The most important drivers being risk premia compression in the euro area having positive spillover effects on CEE, as well as lower implied USD interest rates as a key factor for capital flows. Also, long-term fundamental concepts such as the purchasing power parity and the current account differential drive EUR/USD higher and thus, add to the good sentiment towards CEE currencies.
Sebastian Petric is an Emerging Market Strategist with Raiffeisen Bank International.