EUR: History of deviance – Deutsche Bank

In view of Robin Winkler, Strategist at Deutsche Bank, a key feature of the euro's outperformance during the past months is the deviation from the real rate spread, which still points to fair value close to parity.

Key Quotes

“Historically tight, the causal relationship has completely broken down for the first time since the crisis. An important question, therefore, is whether EUR/ USD is about to 'correct' in line with the rate spread. Our colleagues this week argued that the bullish reallocation dynamic will likely continue to dominate. In this note we provide more statistical evidence that it is not unusual for EUR/USD to ignore rates for periods of half a year. This is in contrast to USD/JPY, on which rates typically reimpose themselves after only a few weeks.”

“Exchange rates tend to be positively driven by (real) rate spreads for long periods of time, but when the relationship breaks down or reverses, that phase tends to be sharp and short. This pattern of 'going up the stairs and coming down in the elevator' is particularly pronounced for crosses that offer high carry and have high beta to risk. But while USD/JPY is known to follow this pattern, how pronounced is it for EUR/USD? To answer this question, we assume that an exchange rate is in one of two 'regimes' at any point in time: rates-driven or not. We then use a statistical model to estimate the probabilities with which exchange rates were in one regime or the other during every week since 2004. This provides a pattern of the rates relationship over time.”

“As one would expect, the model estimates that USD/JPY has generally been rates-driven, but that the relationship frequently breaks down for short periods of time. EUR/USD has also spent more time in the rates-driven regime, but although the relationship breaks down less frequently, it does so for longer periods of time. More precisely, while USD/JPY would typically spend sixteen weeks in the rates-driven regime before switching to the other for seven weeks, EUR/USD typically spends ninety weeks in the rates-driven regime. The difficulty of breaking this regime was one reason for our bearish euro view until the early summer. But the flipside of this 'regime stickiness' is that once the rates relationship does break down, EUR/USD typically spends twenty-seven weeks in the other regime. Statistically, this implies that the rates regime only has a 1/25 probability of reasserting itself the following week, as opposed to 1/7 for USD/JPY.”

“These results suggest that EUR/USD doesn't typically behave like USD/JPY or other carry trades, where the positive rates relationship tends to reassert itself quickly after sharp breakdowns or reversals. The statistical evidence supports our view that the euro's dislocation from the real rate spread can persist into year-end.”