EUR is growing up - SocGen

In view of Kit Juckes, Research Analyst at Societe Generale, for the eurozone, ‘normal’ means a strong(er) currency as the euro is cheaper than the yen on PPP, though not on some other measures.

Key Quotes

“Over the past decade, EUR/USD has averaged 1.29, the same (to two decimal places, anyway) as the OECD’s average measure of purchasing power parity over that period. That isn’t a complete coincidence. Currencies can diverge from PPP for a long time, but they need a reason to do so. In the case of the euro, the reason is monetary policy. The ECB, like the BoJ, has gone on growing its balance sheet and anchoring nominal and real bond yields for far longer than the Federal Reserve or the Bank of England have done.”

“The combination of bond buying and negative rates in place since the start of 2015 saw EUR/USD decouple from relative growth trends, and took the euro deep into undervalued territory. But growth is above trend, the unemployment rate is falling, the existential threat to the system has been tackled for now, and monetary policy is slowly returning to normal. By the time that has happened, the euro is unlikely to be cheap in PPP terms against the dollar (now EUR/USD 1.33) or in REER terms relative to long-term averages.”

“That said, the scale and speed of the bounce in 2017 make things more difficult. “We expect a low around parity for EUR/USD ahead of the French elections before a gradual recovery”. The bounce came far sooner than we expected, and our end-2017 forecast of 1.09 was about 10% too low.” 

“The ECB cares more about the change in the euro’s value than the actual level because that’s what affects inflation most. So, while it was ECB President Mario Draghi’s reference to “tapering” bond purchases in June that propelled the euro to its best level of the year, it has been the subsequent cautious approach to tapering that has stopped its advance. The question now is not so much about the speed at which the ECB will move (it is committed to buying EUR30bn per month until September), but how far into the future the market will look. In the age of low rates, the FX market clearly looks further forward, discounting the destination of policy more than the short-term path, but that still leaves the euro looking stronger than can easily be justified by current levels of policy rates on bond yields, even if the strength of the economic recovery provides justification enough.”

“Our best guess is that the euro’s rise from here will be uneven and, on average, slower than the initial recovery. Our end-2018 EUR/USD forecast of 1.27 is above the consensus, but only represents a 7% gain in 12 months, compared with a 17% gain between January and June of this year. The correlation between the trade-weighted euro’s value and EUR/USD suggests this would add less than 4% to the euro’s real effective rate, taking it just above its average level of the past decade.”