The EUR/USD Exchange Rate Forecast to Remain Supported by Bond Yield Differentials

The US Dollar enjoys positive momentum heading into the new week say Société Generale but  strength may not necessarily extend against a stubborn Euro.

The EUR/USD exchange rate may remain insulated to the Dollar’s onslaught, according to strategists at Societe Generale. 

The call comes in the bank's most recent foreign exchange forecast briefing to clients made at the end of a week that saw the EUR/USD fall by just over 2.5%.

At most risk of a rising Dollar are emerging market currencies which have for years benefited because they have been the only recourse for yield-hungry investors in a ‘negative yield environment’ promoted by Western central banks that have cut their base rates to the bone.

With the prospect of higher interest rates in Western economies over coming years there is likely to be a shift in capital flows that support currencies such as the Dollar.

Also likely to fare less-well are the currencies of the United States' close neighbours such as MXN and CAD, who will suffer due to the new President’s fiercely protectionist agenda.  

“We are bullish on the Dollar against higher-yielding currencies which have benefited from yield-hungry inflows and as long as risk sentiment remains robust we're bullish USD/JPY. EUR/USD is a more complicated story, but may also be a range-bound one, leaving long EUR/JPY (perhaps NOK/JPY and CHF/JPY too) as an attractive trade, but EUR/USD less so,” says Societe Generale's Kit Juckes in a recent note.

The view of a stronger Dollar going forward echoes that held by Commerzbank, as per our note on the matter here.

EUR/USD performed a bearish volte face on election day after it rose to 1.1300 in the initial post-election frenzy, when traders felt the Federal Reserve would delay hking interest rates, before rotating and falling back down as it seemed they might in fact be more likely to hike rates due to Trump’s reflationary stimulus programme.

The long exhaustion bar seemed to open the way for more losses, but the exchange rate has not fulfilled the bar’s potential, churning and struggling lower to 1.0856 but not quite to the 1.0848 lows.

US-EU Bond Yields Supportive of EUR/USD

It's not just Soc Gen who are not anticipating further Euro weakness.

"We believe uncertainty remains firmly in place, and as investors try to assess the political route Mr. Trump will take, the market will be subject to larger-than-usual intraday swings and volatility. Fundamentally, we remain bearish on the USD, as we believe its current level cannot be justified by real rate differentials," says Dr. Vasileios Gkionakis, Global Head of FX Strategy at UniCredit Bank in London.

SocGen also pick up on bond yield differentials agreeing that it is one factor behind Euro resillience is the rangbound spread between German Bund yields and US Bond rates – normally a good indicator of where the EUR/USD exchange rate is going.

This remains rangebound, which indicates no pressure on the exchange rate to move directionally – at least not from yields.

The reason yields are such a driver for currencies is that investors tend to prefer to transfer their money to the currency with the higher yielding bonds, as they get a higher return from owning them, and the flow of international capital is an overriding factor in dictating strength in modern FX markets.

Backflows to Euroland

It is also possible that the Euro may be benefiting from a repatriation flows back into Euros as a result of the sell-off in emerging market financial or otherwise market assets, following Trumps win.

This is an idea put forward by analysts at J P Morgan, who used it to explain which the Euro gained when risk appetite waned.

The extraordinarily low borrowing rates in the Eurozone – which stand at circa  0.0% have led to many investors borrowing in Euros to invest in higher yielding riskier emerging market assets, and pocketing the difference.

Since Trump's win has hit EM assets many of these Euro-funded high risk trades will have been unwound, and the borrowed Euros repatriated, causing temporary increased Euro demand.

Eurozone Banks Back in the Black?

Another positive influence from the outlook for higher interest rates globally, is that higher interest rates will help make banks more profitable.

The environment of low interest rates in the Eurozone has hit Eurozone bank’s profitability heavily, but the new reflationary outlook globally which has attended on Trumps victory, is likely to help bank profitability.

This is of particular importance in the Euro-area where banks have been struggling under the burden of high ratios of Non-Performing Loans, (a hangover from the financial crisis), and because, unlike the US where financing comes from sale of bonds, most business financing in Europe comes from banks.

Political Instability

Balanced against these advantages is the looming negative of political instability.

2017 sees major elections in France, The Netherlands and Germany, with the possibility of a Brexit-style upset, especially in the case of The Netherlands where Geert Wilders anti-EU party is leading in polls on the back of a ticket to take Holland out the EU with immediate effect.

The loss of Holland would be a major set-back for the EU and almost certainly hit the Euro.

On December 4 of this year there will be a referendum in Italy on constitutional reform, which could cause an upset for the government and potentially lead to another general election.

The presidential election in France could see a tangible threat from the National Front and in the Germany there is rising

support for the anti-immigration Afd – although neither in France or Germany are the far right likely to gain power.

Nevertheless the slow erosion of the fabric of the European Union is a very real threat, and is a factor weighing on the Euro’s exchange rate going forward.