EUR/USD: Battling it out - Rabobank

The market continues to scratch its head over the apparent breakdown of the correlation between Bund-US yield spreads and EUR/USD, according to Jane Foley, Senior FX Strategist at Rabobank.

Key Quotes

“Many reasons have been offered as to why a widening differential between Bund and T-note yields have failed to drag EUR/USD lower. Last year a series of scandals affecting the Trump administration, a long wait for a legislative success for the new government and a covering of EUR shorts were driving forces behind EUR/USD.  Fears regarding fiscal mis-management in the US and the cost of hedging are among the factors cited this year for the lack of drag on EUR/USD from rates spreads.  We would also argue that in recent weeks the market has been in a period of transition in which it is attempting to reconcile very different influences.”

“At the start of this year risk appetite was being buoyed by expectations of strong world growth. During much of 2017 rising risk appetite had dampened the outlook for the USD and boosted the performance of high yielding currencies.  Although the Fed signalled that it would continue to hike rates, for some time this has limited impact on broad risk appetite given the underpinnings of strong growth.  This view was tested with the release of stronger than expected US January average earnings data.  The increase in US bond yields and the sharp drop in equity markets in early February was evident that the market was paying greater attention to the risk of higher inflation and Fed rates.  However, although the relations between higher treasury yields and EUR/USD has not been clear cut over the last month, there is evidence of stronger USD vs. many emerging market currencies.”

“In the month to date the USD has outperformed all Asian and G10 currencies, with the exception of the safe haven JPY. It has also outperformed all CEE currencies apart from the UAH and all Latam currencies aside from the CLP.  Although our house view remains on the dovish side of market expectations, speculation that the Fed may be prepared to consider hiking rates four times this year was boosted yesterday by the upbeat remarks on the US economy from Fed Chair Powell.  The resultant push higher in US yields has provided additional support to the USD which has pushed EUR/USD today to its lowest levels since mid-January.”

“The pick-up in US inflationary concerns this year combined with market expectations that Fed hawks could gains the upper hand are likely to continue tempering risk appetite. It is our view that the USD will gains ground vs. a broad spectrum of ‘high yielding’ currencies in the months ahead including the AUD and the NZD.  Given their safe haven characteristics, both the JPY and the CHF are likely to be better supported going forward given the drop in risk appetite.  That said, we continue to see scope for the EUR to hold its own vs. the USD based on strong growth in the Eurozone and the present of a strong current account surplus in the Eurozone.”

“Our more dovish than consensus view on US inflation pressures and the Fed also suggests that upside potential for t-note yields should be tempered and that concerns about a reduction of USD liquidity should remain ordered.   For these reasons we retain a three month EUR/USD forecast of 1.25, though we concede that this seems further away than it did just a few weeks ago.”