The euro tested 1.21 against the US dollar last week, its highest level in five months, while the gap between two-year US Treasury and German bond yields surged past 2.58% on 10 January, its widest spread in more than 18 years. Higher US short-term bond yields might be expected to draw capital inflows away from Europe and drive up the dollar’s value, but it doesn't appear to be the case this time.
While we believe rate differentials remain important to watch, scope for further widening is limited, with the European Central Bank following the US monetary policy normalization path, and with US rates likely to approach terminal levels over the next two years. We believe other factors will more than offset the US dollar's yield advantage this year:
- Spreads indicate absolute rate differentials; the FX market is likely to focus more on incremental policy moves. With US inflationary pressure still limited, there is little need for the Fed to act more aggressively, while the ECB has signaled it will start to pare back its stimulus.
- Current account dynamics continue to favor the euro. The bloc’s current account surplus of around 3% of GDP contrasts with the US deficit of 2%. This means that, all else equal, the real economy demands euros and supplies dollars, regardless of rate differentials.
- The euro remains undervalued. Despite recent appreciation, EURUSD remains more than 6% below our estimate of purchasing power parity at 1.27.
We expect FX markets will continue to look past US-German yield spreads, and focus on Eurozone export dynamics, and an undervalued euro. We retain our year-end EURUSD forecast of 1.25.
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