The EUR/USD currency pair, which expresses the value of the euro in terms of the U.S. dollar, has rapidly reversed in its trajectory recently. The pair has risen sharply, from prices in the 1.0750 to 1.0800 range (between February 18 and February 21) to over 1.1000 in the trading week which ended February 28. This recent surge, as shown in the daily candlestick chart below, coincided with an extremely sharp fall in global equities.
(Chart created by the author using TradingView. The same applies to all subsequent candlestick charts presented hereafter.)
The sharp rise is likely due to an unwinding of speculative positioning. The European Central Bank maintains a deposit facility rate of negative -0.5%, a rate which translates into low euro funding costs via trading intermediaries and currency brokerages. Traders are able to borrow euros cheaply, convert these into U.S. dollars (often on a leveraged basis), enabling them to generate interest income. This continues to place long-term pressure on EUR/USD.
The rise in EUR/USD recently follows a sharp correction in U.S. equities. When risk assets like U.S. equities drop, we can assume that carry trades will unwind (this includes short-EUR/USD positions). This is because when underlying assets drop in value, leveraged carry-trade positions become especially vulnerable to margin calls. Money therefore flows back to where it came from as these positions are unwound.
These sorts of reactionary moves can precipitate when other traders anticipate such moves occurring. In other words, understanding the carry-trade dynamic can strengthen the correlations between risk asset prices and carry trades, as traders attempt to "front-run" the reactionary moves. The correlations are, for example, traditionally positive between U.S. equities and USD/JPY, and negative between U.S. equities and EUR/USD. Whether capital is reactively repatriated or not, we can expect these sorts of relationships to persist to varying degrees.
The sharp fall in U.S. equities helped to support EUR/USD upside, however the negative interest rate differential for EUR/USD remains. This can be calculated on the basis of central bank rates. The ECB rate of -0.50% compares to the U.S. Federal Reserve's comparable target rate of 1.50-1.75% (midpoint: +1.63%). If we subtract the midpoint of the U.S. target rate from the ECB rate of -0.50%, we arrive at a net interest rate differential of -2.13%.
Therefore, while we recently witnessed a sharp rise in EUR/USD, it is unlikely that the upside will continue for much longer. Pressure will continue to mount, and as the week has now ended, it is likely that the most leveraged positions concerned have been unwound prior to the weekend. Going forward, unless we see another sharp decline in equities, even a mere consolidation in global equities would likely support a lower EUR/USD.
The point here is, the recent rise in EUR/USD was likely largely mechanical, and not based on fundamentals. In the long run, currency prices will gravitate towards the fundamentals. The pressure on this pair will likely hold, given the wide interest rate differential.
Having said this, the Fed chairman Jerome Powell recently implied that the Federal Reserve would consider cutting rates to support the economy, should the risks surrounding the coronavirus begin to manifest in negative actualities. As reported in the Wall Street Journal:
While the fundamentals of the U.S. economy remain strong, “the coronavirus poses evolving risks to economic activity,” Mr. Powell said in a statement released Friday afternoon. “The Federal Reserve is closely monitoring developments and their implications for the economic outlook. We will use our tools and act as appropriate to support the economy.”
Markets have therefore repriced short-term U.S. yields. Yields move inversely to bond prices; the recent rise in bonds follows the recent risk-off sentiment. However, since the ECB already has negative rates, the market has evidently put more pressure on short-term U.S. rates as opposed to European bond yields. The chart below shows EUR/USD price action, again using daily candlesticks, alongside the spread between U.S. and German one-year bond yields (Germany is used as a proxy for short-term European rates).
Set against the far-right y-axis, we can see the one-year spread for EUR/USD has rocketed up to approximately -1.75%, a still-negative but nevertheless much higher spread than we were used to seeing, only mere days ago. This spread compares to our central bank rate spread of -2.13% (as we calculated previously), a difference of 38 basis points.
The chart below shows substantially the same as the chart above, except the one-year interest rate spread is broken up to reveal the two different yields. The new far-right y-axis has been added to accommodate the U.S. yield, shown in green, whereas the blue line now represents the German yield alone.
We can see that money has flowed into both German and U.S. bonds, a global risk-off move, sending the yields of the short-term bonds of both countries quickly downward. It is the fact that U.S. bonds have felt more pressure that the net difference has spiked in favor of EUR/USD upside (likely given that investors believe the ECB has less room to cut rates, given that they are already negative by 50 basis points).
In any event, in this author's opinion, we are likely to find see a similar consolidation as we saw in June 2019, when a similar bond market repricing occurred (as highlighted in the chart below, which shows the one-year bond yield spread as before).
A spike in the interest rate spread in June 2019, which momentarily peaked on June 2019 (before consolidating) sent EUR/USD higher, but then quickly lower following this consolidation. While we must admit that EUR/USD then made another subsequent attempt to rise later that same month, the pair has ultimately not come close to the June 2019 high since such time.
It is also worth noting that since June 2019, the interest rate spread has risen consistently, yet because it has remained safely negative, the pressure on EUR/USD has continued. The euro will continue to remain under pressure unless we see U.S. rates being cut to zero, which is far from a base-case scenario.
In the near term, provided that U.S. equities do not make further near-term lows, EUR/USD is likely to reprice downward. It is important to remember that the euro zone and the United States are the two largest economies in the world, and the euro is not merely a vehicle for speculation. The short-term mechanical upside does not follow a significant shift in underlying economic fundamentals, and therefore we should view the recent spike with great skepticism in the short term.
The table below presents upcoming central bank meetings; the ECB's next meeting will be held on March 12, 2020, while the Federal Reserve's next meeting will come afterwards on March 18, 2020.
It is probable that we see near-term downside and then consolidation in EUR/USD leading into these meetings. Should the ECB not cut rates or announce any significant changes to monetary policy (which may well be the case, in spite of recent bond market moves), we might see the euro strengthen again momentarily (prior to the Fed's meeting on March 18). In the meantime though, downside risks exceed upside risks.