Hawkish
That is why ECB President Christine Lagarde’s hawkish comments on February 3 are important.
Lagarde emphasised that inflation risks were “tilted to the upside,” and chose not to repeat her previous assumption that a rate hike this year is unlikely. A couple of days later, Klaas Knott became the first ECB governor to forecast a 2022 hike. Negative consequences for peripheral eurozone credit spreads led to some message moderation last week, but in our view the change of tone is clear.
For a week, it helped to narrow US dollar and euro interest rate differentials—until Thursday’s US inflation data and Fed hawks sent US yields soaring. But the reason we think the euro could build a base at current levels is that the change of tone at the ECB could lead investors to shift their attention back to factors other than rate differentials.
Flows
What might those factors be?
First, when we start to consider hiking rates from below zero, we believe it’s not only rate differentials that are important, but European rate levels. It’s worth noting that, according to Bloomberg data, the value of negative-yielding assets has more than halved since the start of the year, from $11 trillion to $5 trillion. A large proportion of those assets are European.
ECB data suggest that capital flows out of Europe, mostly into US dollar assets, started to pick up speed when the central bank cut rates below zero in June 2014. Due to negative euro rates and wide rate differentials, some of the capital that went into US fixed income, and most of what went into US equities, is likely to have been unhedged. Moreover, some investors’ mandates prohibit them from investing in negative-yielding assets.
We see growing incentives to implement hedges or reverse those seven years of flows, creating balancing demand for euros.
Growth Surprises
Second, looking past headlines such as January’s payrolls number and inflation, recent US economic data has surprised on the downside, especially relative to Europe’s. Consensus growth estimates for 2022 now have the US at 3.8% and the eurozone at 4.0%. Tighter financial conditions could make things more difficult for peripheral eurozone borrowers, but we are not in 2011 anymore; the collectively financed NextGenerationEU pandemic recovery plan has substantially reduced perceptions of eurozone break-up risk.
And finally, there is the unspoken importance of exchange rates for the ECB’s price-stability mandate. As we know, central banks have refrained from targeting currency levels, but they do matter for inflation. When inflation is well below 2% and oil is $60/bbl, a weak currency is desirable. With oil at $90/bbl and inflation at 5%, a stronger currency would help to ease the pain of Europe’s energy import bill
Add it all together, and we believe the euro is building a base at current levels. Should US rates stabilise, and especially if we see US growth begin to lag global growth, we think there may be upside to come.
Will there be difficult, volatile moments? Most likely. Thursday gave us a taste of the potential for US inflation and policy surprises. But aren’t all love affairs volatile from time to time? Ultimately, we think the euro and the market are laying the foundation for a long and happy relationship.
