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Euro 2021—Running in Place
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Andrew Kositkun Foreign Exchange Head Trader
The euro finally broke its two-year losing streak against the U.S. dollar (USD) this year. A key driver of the euro’s gains was the pandemic driven collapsed of global interest rates that triggered a rebalancing away from overweight positions in formerly high-yielding currencies, such as the USD, and into under-owned and undervalued currencies, such as the euro, as U.S. exceptionalism took a hit.
The abrupt drop in rate spreads allowed the euro to benefit from the largest current account surplus in the G10 and materially large long-term capital inflow. Additionally, a historic political breakthrough (EU rescue fund) in response to COVID-19 issues helped with euro strength. The EU rescue fund not only backstopped growth, especially in the periphery, but the agreement on limited risk sharing also helped avoid euro breakup fears that inevitably come during a recession. Only time will tell if this is a step toward a fiscal union, but the collective and cohesive policy response was warmly welcomed by investors.
Looking ahead to 2021, further euro gains should be harder to come by. Three of the four key drivers of 2020’s euro rally are already or close to neutralizing. These include the improvement in rate spreads and associated portfolio rebalancing, one-time repricing of euro tail risk and cheap valuations. This leaves the region’s current account surplus as the principle remaining driver, but even this is starting to fade in strength. The fading of fundamental drivers is illustrated by EUR/USD’s sideways trading over the past three months. Ultimately, the outlook is for a continuation of the recent choppy trading but in a narrower range. Over the medium term, a step-up in growth due to vaccine progress and EU recovery fund spending will likely help the euro go higher, but the single currency should dip again into year-end as U.S. yields rise and the European Central Bank (ECB) continues to fight a lack of inflation.
Unlike in 2017 when the euro rallied due to economic performance, 2020’s rally came despite the economy underperforming. This is important because the decline of U.S. exceptionalism likely won’t persist, and the rebalancing flows from overweight currencies to underweight currencies, while potentially protracted, are inherently transitory absent European economic outperformance.
To this end, it is worth mentioning that the euro exchange rate is discounting a more robust European economy than macroeconomic models and equity markets would otherwise suggest. Clearly, there is always uncertainty around models, but the equity market disconnect is of particular interest given the strong 90%+ correlation between relative U.S.–European equity and economic performance over the past two decades.
Furthermore, inflation developments could have a larger than normal role on the euro’s path. Much news has been made of the Fed’s shift in its inflation framework, and this shift certainly means the Fed will tighten policy later than it would have previously. But it will eventually tighten. Conversely, the euro area faces record-low core inflation, meaning the ECB has a bigger inflation challenge even if its policy review results in a less radical change that the Fed’s review. So while markets are not expecting further rate cuts, they are also pricing in hikes in Europe two full years after the Fed’s first projected move.
Overall, the euro outlook assumes a drop into year-end on the assumption that markets will focus on questionable domestic growth fundamentals once the distraction of the pandemic and Fed repricing is in the rearview mirror. In essence, without the benefit of cheap valuations, it is difficult to see a sustained euro rally without European exceptionalism and the prospect of ECB rate hikes.
HERE ARE THE KEY NEWS STORIES FROM OVERNIGHT:
U.S. fiscal stimulus efforts have picked up again. Unsurprisingly, the size of the potential package remains in flux, but both sides appear more open to compromise. The latest effort stems from a bipartisan group of rank-and-file senators that have put together a $908 billion package that would include an extension of unemployment benefits as well as state and local aid. For context, Senate Republican leadership has proposed a $500 billion plan, with House Democratic leadership proposing a $2.4 trillion plan. It is worth nothing that Senate Majority Leader Mitch McConnell has already rejected this compromise and has circulated a new version of the Republican Senate plan that’s still in the $500 billion range.
The U.S. ADP jobs report came in softer than expected at 307,000 versus expectations for a 440,000 print. This disappointment aligns with a pickup in weekly jobless claims and illustrates a labor market under stress. The government jobs report is scheduled to be released this Friday.
President-elect Joe Biden will leave the Phase 1 deal between the U.S. and China in place, as he reviews the U.S. policy toward Beijing in consultation with allies. Biden will also do the same with existing tariffs. In the past, Biden has shown disapproval of tariffs but their removal will be gradual at best. More broadly, China should not expect less pressure from the Biden administration even if it removes some or all of the trade war tariffs. The removal of tariffs just signals a different approach, but the U.S. hard-line on China is here to stay.
The U.K. has become the first country to approve a COVID-19 vaccine after the country approved the Pfizer and BioNTech shot. Vaccinations will begin shortly with 800,000 doses already ready. The FDA is holding its advisory committee meeting on this vaccine on Dec. 10, with the first shipment of Pfizer and Moderna vaccines due Dec. 15 and Dec. 22, respectively. The EU is scheduled to review the Pfizer vaccine on Dec. 29.
Brexit talks have hit a snag, but this is not unexpected. The latest headline indicates pushback from the EU over fisheries and a level playing field. Despite the latest setback, markets are still expecting a skinny deal this week as talks have entered the “tunnel” phase.
Australian third-quarter GDP beat expectations, at it rose 3.3% quarter over quarter versus expectations for a 2.5% increase.
The euro area unemployment rate rose 0.1% to 8.4% which is in-line with expectations.
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