Foreign Exchange Research 10 September 2014
Trend depreciation has begun
We now see a more protracted and significant slide in the EUR and are revising our forecasts substantially lower over a 12-month horizon. While our recent forecasts for EUR depreciation have proven accurate, the deterioration in the euro area economic and inflation outlook and the European Central Bank's (ECB) response to it lead us to expect more substantial depreciation. We expect this to be a multi-year trend, returning EURUSD to lows not reached in more than a decade. As a market consensus develops about this idea, we expect already negative hedging costs at a multi-year horizon to accelerate the EUR's slide as long-term investors and corporates substantially adjust their hedge ratios.
We are revising our forecasts for EURUSD to 1.27 in 1 month, 1.22 in 3 months, 1.17 in 6 months, and 1.10 in 12 months
Recent data from the euro area have been profoundly disappointing, in terms of both real activity and inflation. Growth has slipped back to zero – with the German economy actually contracting in the second quarter – and PMIs suggest activity will remain subdued.
Meanwhile, inflation has fallen unexpectedly further, to just 0.3% y/y (we expect it to bottom this month at 0.2%), and long-dated break-even inflation measures dipped briefly below 2%. Reflecting this poor outlook – and expectations that rates in Europe will be low for a long time – 10-year yields of German bunds have fallen to all-time lows and the US Treasury-bund spread has widened dramatically from already wide levels (Figure 1).
These events prompted a powerful reaction from the ECB at its September meeting, first hinted at in President Draghi's Jackson Hole speech, where he re-emphasized the ECB's willingness to do whatever it takes to reinvigorate inflation. As a demonstration of that commitment, the ECB announced a further cut in interest rates, including in the deposit rate to -0.20%; the beginning of ABS purchases in October; the addition of covered bonds to that purchase program; its intent to return its balance sheet size to previous highs; and the possibility of doing more as needed. The addition of covered bond eligibility to its purchase program ensures that, regardless of the net uptake from the upcoming TLTROs, the ECB will provide sufficient excess reserves of the banking system to push EONIA towards its (below zero) floor.
The effect on interbank interest rates has been dramatic, with the EONIA swaps curve now pricing significant negative interest rates through the 4-year tenor (Figure 2). Inflation expectations, as measured by break-even inflation swaps, have turned sharply at all tenors
(Figure 3).
However, the ECB clearly has its work cut out for it. The turnaround in break-even rates only unwinds their summer dip; they still trend downward at all tenors. As a result, euro area real interest rates have only just returned to their level at the June ECB meeting, and European equities in USD terms still are well below their June level (Figure 4).
Yet twice in the space of four months, the ECB has managed to exceed market expectations for policy significantly, taking actions that many thought unimaginable in the late spring, including negative policy rates, the cessation of SMP sterilization, and new asset purchases.
While the latest actions did not attain unanimity on the Governing Council of the ECB, we continue to expect President Draghi to push through all necessary measures with "a comfortable majority," as in the September meeting. This "whatever it takes" approach should keep euro area interest rates low for a long time and ultimately push inflation back up from its recent lows.
As a result, we expect real interest rate differentials to continue to shift against the EUR. While recent EURUSD declines appear to have outpaced the current real interest rate differential between the euro area and the United States, it has not exceeded forward real interest rates (Figure 5). Furthermore, we expect the real interest rate differential to continue to move in favor of the USD, beyond what is projected by market forward rates.
For instance, the current 1-year euro area less US rate differential is 75bp. Under our forecasts for the coming year, rising US interest rates and a pickup in euro area inflation that (slightly) exceeds the US should subtract about 140bp from that spread, nearly 100bp more than implied by the 1y1y forward real rates and roughly equal to the shift implied by 1y2y forward real rates. The shift in real rates that we envision should keep EURUSD under pressure for the next few years.
Beyond the change in real interest rate differentials, there is also an important effect that comes from the creation, or expectation, of a persistent interest rate differential in level. The Great Yen Carry trade from late summer 1995 until the LTCM crisis of fall 1998 was driven
by a steady, wide, positive interest rate differential between the US and Japan and expectations that post-crisis, Japan's economy would underperform for an extended period. Once expectations for steady JPY depreciation became the consensus, the carry trade became entrenched.
One key difference between the JPY in August 1995 and the EUR today is that while both currencies had just come off sharp depreciations, the JPY was still relatively strong in multilateral terms. The EUR is already below its equilibrium value by our measures. However, the EUR is roughly where it was in August 1999 in real effective terms, just before it dipped to its all-time nominal lows, roughly a 13% real trade-eighted move, about the size of the move we are forecasting.
Furthermore, the level effect may be greater than in the Great Yen Carry trade, given the ECB's creation of negative money market rates. With EONIA 5-7bp below zero in nominal terms through four years and the EURUSD basis 10-20bp negative out to ten years, longterm investors and corporations have a stronger incentive to hedge further out the curve, importantly, euro area banks have a strong incentive to provide them with the funding for those hedges as a way to escape punishing negative deposit rates at the ECB.
Risks to our forecasts
Our forecast is aggressive and not without risks.
We see three key ones:
1) the ECB fails to fulfil its commitment to do "whatever it takes" to continue to drive inflation expectations higher and real interest rates lower;
2) the ECB, alone, lacks the tools to raise euro area inflation;
3) the ECB is more successful than we expect.
There is much skepticism that when push comes to shove, the ECB will overcome the opposition of some of its members – or some Northern European governments – to take any and all feasible actions to reflate the economy. Euro area inflation is at worryingly low levels in large part because the ECB was too late to react and take disinflationary threats more seriously. However, President Draghi has repeatedly shown that when action can be delayed no longer, he can push the Governing Council to unanimous action, as in June, or override even the most vocal minority, as in summer 2012 or at the most recent ECB meeting.
Another risk is one that President Draghi himself repeatedly has highlighted: that the ECB cannot do it alone. Structural reforms that only the fiscal authorities can make are needed to raise euro area growth beyond anaemic levels, and there is a risk that without them, the ECB will not be able to raise inflation, regardless of the actions it takes. This could push the euro area into permanent deflation that would create pressures for nominal appreciation of the currency. While this is a legitimate risk, we believe that central banks do have the tools to create inflation, even when they cannot affect real variables.
The opposite is also a risk: that the ECB is more successful than we expect, raising both growth and inflation faster than expected. Such success likely would reverse recent trends in interest rates, raise real expected returns to capital in the euro area and lead to an early end to the trend of EUR depreciation that we expect. This would be a happy risk to our forecast, but the significant impediments the euro area faces to growth, unfortunately, give us confidence this will not be the case.
We see much less risk from the balance of payments. As we have often noted, the counterpart of every current account surplus is a capital account deficit, and given the euro area's dour outlook and large inflows in 2012 and 2013, we see only weak pressures to offset the euro area's net capital outflow. Furthermore, with negative money market rates and basis, we expect most inflows to be currency hedged.
