Why the Euro Bear Market is Only Half Over

ECB, Fed, EMU, Why, Euro, Bear, Market, Only, Half Over, fundamental analysis, fx trader, forex

13 Mar 2015

It is precisely because the euro's decline in over-determined that the slide has accelerated. It is not just that the ECB is buying sovereign bonds. It is not just that the strength of the US labor market has persuaded more participants that the Fed will lose its "patience" (as in forward guidance) next week. It is not just the European officials have yet to convince investors that EMU is irreversible. It is the fact that all three forces are operative.

These forces have conspired to get rid of the incentives global investors have for holding on to euros. Using Germany as a proxy, look at what has happened to interest rate differentials. The US 10-year yield is about 192 bp more than Germany. This is the widest since the late 1980s. The premium was only 166 bp at the end of February. The 2-year premium of 93 bp is an eight year high.

Moreover, consider the premium relative to German yields.  A 192 bp premium the US offers on 10-year money compares with 20 bp the benchmark 10-year bund now offers. That is to say that the US yield not just a little larger than Germany, but 10-times more. At the 2-year part of the curve, one has to pay the German government for the privilege of lending it money. The US Treasury pays 70 bp to borrow your money.

Not only does the euro-based investor lock in a significantly higher yield by investing the US, but they also get the dollar exposure as a kicker. Already this month, the dollar has risen by more than 5% against the euro. Simply stated, euro-based investors are paid to be long US dollars. Anecdotal reports suggest that some financial institutions in the euro area are promoting dollar deposits for their euro-based clients. 

The weak euro and low interest rates are fueling a surge in US corporates issuing euro-denominated paper. A year ago, one was paid about 6 bp to swap the euros into dollars (per year) for five years.  Now one is paid nearly 40 bp.

If the interest rate differential stabilizes here, it is dollar-positive, but here is no compelling reason to think that the interest rate divergence has peaked yet. The ECB's bond buying program has just begun. The Federal Reserve has not yet raised rates.