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Why the Euro’s Surge Could Last

Posted by hkarner - 14. Juli 2017

Date: 13-07-2017
Source: The Wall Street Journal

As the risk of a eurozone breakup fades, indicators suggest investors are increasingly positive about the currency’s prospects

Investors are betting that the euro’s value will appreciate for the first time in three years.

Once dubbed a crisis currency, the euro has outperformed its peers against the dollar and investors are betting there are gains to come.

The euro is up 10% against the greenback so far this year, as the local economy rebounds and the threat from populist politicians calling for the currency zone’s demise recedes.

With the risk of breakup fading, analysts are asking whether the currency can reclaim some of the global standing it held before 2009 and the sovereign debt crisis, not least as central banks place more of the currency into their reserves.

Multiple indicators suggest that investors are more positive about the euro than for many years and on Wednesday the currency traded at $1.149, its highest level in over a year.

“Political threats to the euro have definitely reduced its status, and from a historical perspective the rest of the world is underweight Europe,” said Carl Hammer, head of global macro and foreign exchange research at Swedish bank SEB.

Three-month euro-dollar risk reversals, which measure the cost of hedging against drops in currencies, broke into positive territory at the end of June for the first time since at least 2010. A positive figure suggests investors are no longer asking to be paid a premium to hold euros, a sharp change from the recent past.

Investors also have a net long position in the euro—a bet that the currency will appreciate—for the first time in three years. The U.S. Commodity Futures Trading Commission data shows investors held 77,464 more long than short contracts on the euro in the week to July 3.

The European Union has long hankered for a greater role in global markets. As far back as the 1960s, Valéry Giscard d’Estaing, France’s then finance minister, complained of the U.S. dollar’s “exorbitant privilege” as the pre-eminent reserve currency. Following its launch 18 years ago, the single currency reached a high of around $1.60 in 2008.

But the currency has lost ground even since the sovereign debt crisis ended in 2012.

Its share of daily turnover in foreign exchange markets has dropped from 39% in 2010 to 31% in 2016, according to the Bank for International Settlements.

The European Central Bank estimates that the share of international bonds denominated in euros has dropped from as high as 29.3% in 2004 to 22% at the end of last year.

In the first quarter of the year, slightly less than 20% of global official foreign exchange reserves were held in euros, according to the International Monetary Fund. At its peak in 2009, the euro’s share of international reserves reached nearly 28%.

Aside from prestige, a greater international role would help eurozone companies raise funds while potentially reducing exchange rate volatility. The dollar’s role as the most important global reserve currency has typically been seen as a boon for the U.S.

The lingering risk that the currency won’t survive has reduced the euro’s position in foreign currency reserves held by governments and central banks while putting off some investors.

“If you’re a reserve manager, say in Asia, you would think twice about investing over the very long term in a currency that might not exist in five years,” said Dhaval Joshi, chief European strategist at BCA Research.

That risk has abated recently. Elections in the Netherlands and France saw pro-EU candidates win convincingly, and support for Germany’s main anti-euro party has dwindled.

Expectations that a country will leave the eurozone have fallen. Investors currently assign an 8.6% probability to a country exiting the eurozone in the next 12 months, against over 25% early in the year, according to the Sentix euro breakup index, which polls investors on their expectations for the bloc.

The brighter outlook for regional growth, which has recently outstripped the U.S., helps the euro on multiple fronts. It reduces the risk of breakup by helping to bolster the weaker southern European economies, whose debts and stagnant growth helped to fuel the sovereign debt crisis. It makes the region more attractive for outside investors.

It also means the ECB will be quicker to jettison the bond-buying and negative interest rate policies that have capped the currency’s gains. Such so-called quantitative easing, QE, policies keep bond yields low, reducing long-term returns for investors and stemming the flow of foreign exchange that would boost the euro.

It may even see other central banks stock up their reserves.

“It could be that the first quarter represents something close to the low in the euro’s share of reserves,” said Stephen Saywell, head of foreign exchange strategy at BNP Paribas .

To be sure, factors such as less monetary stimulus and a brighter economy could end up hurting the euro if the pace of both disappoint. The region’s anti-euro politicians could also stage a comeback.

But the prospect of higher interest rates and other factors have already led many analysts to hike their forecasts for the euro in the short term.

Earlier this year Deutsche Bank and Morgan Stanley expected the euro to drop below parity with the dollar. Both have now raised their projections by 21 cents to $1.16 and $1.18 respectively. HSBC analysts who began the year with a $1.10 forecast now believe their current $1.20 projection may be a conservative estimate.

“Before Europe started the QE program we were comfortably above $1.20, so if that’s going to be withdrawn, you’ve got to ask why the euro can’t go much higher by this time next year,” said Steve Jefferies, head of currencies and emerging markets in Europe, the Middle East and Africa at J.P. Morgan .

 

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