By Ugo Lancioni, head of global currency at Neuberger Berman
When the European Central Bank adopted a much more hawkish tone on February 3, it gave the EUR/USD exchange rate a substantial boost. A week later, a 7.5% US inflation print, followed by some exceptionally hawkish statements from US Federal Reserve officials, led to some very volatile price action.
We think the ECB’s change of tone is significant, bringing us closer to a situation where economic and technical dynamics are more fully aligned with a stronger euro. As such, Thursday’s tug-of-war around current levels suggests to us, not a renewed threat to EUR/USD, but a signal that a base is being built underneath it.
On this Valentine’s Day, the market may be ready to commit its affections to the euro.
That would be a big change from last year’s Valentine’s Day, when the market left the single currency hanging.
The EUR/USD exchange rate started 2020 at 1.10. By February 14, 2021, it had risen above 1.20. Over the course of the rest of the last year, it came all the way back down to 1.12. The euro has risen and fallen depending on which economic or technical dynamic the fickle foreign exchange market has been focused on.
During 2020, it focused on why the euro looks undervalued against the US dollar, particularly on a long-term view.
For example, real effective exchange rates and purchasing power parity (PPP), which take into account what a euro or dollar can buy locally, suggest that the nominal EUR/USD rate is between 10% and 15% undervalued.
Relative current account balances also strongly favour the euro. The eurozone has a surplus of almost 3%, the US a deficit of more than -3%.
Interest Rate Differentials
Once the recovery from the pandemic reintroduced the potential for tighter monetary policy, however, the market moved its focus to interest rate differentials.
This pulled the euro out of favour. While the US Federal Reserve and other central banks grew more hawkish, the ECB seemed reluctant to give up on the idea that the spike in inflation would prove transitory. In the second half of 2021, especially, the euro began to move in lockstep with the spread between euro and dollar rates.
At the same time, a combination of strongly outperforming US equities and the swath of negative-yielding European bonds kept capital flowing westward across the Atlantic. Many of the long-euro positions built up during 2020 were unwound.