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Why the euro has appreciated – and why it will keep appreciating


The euro, taken in effective terms, remained quite stable throughout 2016 and early 2017. Only in April did an appreciating trend emerge. This has not been a straight-line appreciation, and three events have "boosted" the euro directly:

  • The dismissal of FBI Director James Comey on 9 May, and the launch of a special investigation directed by Robert Mueller on 17 May: US long-term rates fell, while German rates remained stable.
  • Mario Draghi's speech at Sintra on 27 June ("Accompanying the recovery") during which he was more optimistic on the medium-term inflation outlook and spoke of adjusting monetary policy parameters.
  • The Governing Council meeting of 20 July during which Mario Draghi explained that a recalibration of monetary policy would be discussed in the autumn. 

The first two of these three events caused the 10-year rate spread between the US and Germany to narrow from 200bp in early May to less than 180bp in late July, which pushed the euro upward against the US dollar. On the other hand, the euro's appreciation since late July is different, because the euro's effective exchange rate has increased despite a slight narrowing of the US/Germany rate spread.

The EUR/USD exchange rate has risen slightly since the Governing Council met on 20 July, particularly with the threats from Russia and Saudi Arabia on 24 July about the implementation of oil production cuts causing a spike in prices, but the top contributor to the rise in the euro's effective exchange rate was the pound's precipitous drop: the EUR/GBP exchange rate reached 0.92, which is now very close to historic highs, due to economic figures, which continue to disappoint, and a lack of clarity over the UK’s Brexit strategy. The Swiss franc's sudden depreciation should also be highlighted, with the EUR/CHF exchange rate moving from 1.10 in late June to 1.14 today.

As we have just seen, several factors – not necessarily related to one another, and some of which could play in the other direction shortly – are behind the trade-weighted euro's climb since April, but the most important one is still the long-term interest rate spread.

German long-term rates remain too low, because breakeven inflation is still exceedingly weak. The upcoming announcement of a reduction in sovereign bond purchases should help to raise long-term rates and, over the next several months, the long-term spread between the US and Germany is likely to continue to close, slowly but surely, which would drive EUR/USD upward.

We should remind one thing: the euro has depreciated in 2014-2015 because European residents had massively bought up foreign securities, which more than offset the eurozone's huge current account surplus. The Eurozone runs the most important current account surplus in the world, what should be supportive for the currency. For a year now, we have been watching a decline in the intensity of portfolio investment outflows, which is expected to accelerate. As a consequence, the basic balance (sum of the current account, net FDI flows & net portfolio investment flows) has started to become less negative, what is exerting an upward pressure on the euro. In conclusion, it is unlikely that the euro's appreciation will continue in such a straight line, but our conviction is that the euro will be stronger 6-12 months from now. In particularly, the EUR/USD parity will be higher, despite the excessive pessimism about the US economy and the continuation of the Fed’s tightening cycle.

2017-08-25 - graph
DRUT Bastien , Fixed Income and FX Strategy
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Why the euro has appreciated – and why it will keep appreciating
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