US$500 billion ‘of demand’ is poised to push the euro even higher

The notion of further euro strength has become a self-fulfilling prophecy

PUBLISHED : Tuesday, 25 July, 2017, 7:48am
UPDATED : Tuesday, 25 July, 2017, 10:47pm

The euro express is moving along the tracks and heading north. That leaves investors in Asia and indeed globally, many of whom are underweight in euros, with some big decisions to make. Is it too late to jump on board or has the euro further to run?

The euro hit a near two year high versus the US dollar last week, rising also against the yuan but in deciding how to react, potential buyers of euros have to consider a number of issues.

An evaluation of the existing drivers of the move is important. But investors also have to make a judgement about the current structural position in the market and how that guides future investor behaviour.

Two main factors are arguably currently driving euro strength versus the greenback.

Firstly, and this also extends across the broader currency universe, investors have been pulling money out of the US dollar, having judged that the economic stimulus programme that stood at the heart of the Trump election platform, and which initially fuelled demand for US assets following his election, isn’t going to happen any time soon.

The greenback’s fortunes are also not helped by Trump’s domestic political distractions and a perception that the market has already priced in Federal Reserve policy tightening into the greenback.

On the euro side of the equation, there has been a growing market perception that an apparent diminution of political risk, combined with improved euro zone economic data, lends itself to some withdrawal of European Central Bank (ECB) monetary accommodation and by extension supports a higher value for the single currency.

Back in April, HSBC predicted this situation could unfold and raised their year-end forecast for euro/dollar to $1.20. That now looks prescient.

Comments on June 27 from ECB President Mario Draghi raised market expectations for some withdrawal of monetary accommodation, driving the euro, as US firm BNYMellon has pointed out, 2.8 per cent higher versus the greenback by last Thursday’s latest ECB policy meeting.

In the event the ECB stood pat on monetary policy. As for the euro, if Draghi had qualms about it then, given that markets hang on his every word, all he had to do last Thursday was to make that clear. He didn’t.

Instead, when Draghi was given the opportunity to comment on the euro he merely noted that “the repricing of the exchange rate has received some attention during the various exchanges and in various ways”.

His failure to overtly push back against the euro’s recent rise was not lost on the currency market which proceeded to push the euro higher. Whether Draghi was motivated by ambivalence about the currency’s move, or had just concluded that the drivers of euro appreciation are impervious to rhetoric, is irrelevant.

Market participants rightly perceived the line of least resistance was to take the euro yet higher. And once the market decides it feels the euro is likely to be higher tomorrow than today, then those who don’t have euros have a big decision to make. A “buy a dip in the euro” strategy can emerge which, if unsuccessful, can become just “buy”.

Layered on top of short-term market sentiment is a sense that investors as a whole may not have yet boarded the euro train.

HSBC noted last week that while “fast” money may have turned more bullish on the euro, “slower” money such as fixed income, equity portfolio and reserve managers have yet to fully embrace it.

Reserve managers, of which many of the largest are in Asia, have, as HSBC shows, steadily reduced their holdings of euros over the last seven years. If such investors warm to the pro-euro theme “then there could be a significant amount of euro to be bought,” perhaps, HSBC contends “upwards of US$500 billion of demand”.

Putting US$500 billion behind an already moving train will boost its momentum. Even the perception could have the same effect.

It becomes almost academic whether individual traders, banks or investors think a stronger euro is justified or not. Those who stand in front of a moving train tend to fare badly. The choice becomes either jump on board or stand aside.

But if the train keeps rolling on, investors who choose to stand aside risk being compared negatively to those who got on board. The temptation is to go with the flow. The notion of further euro strength becomes a self-fulfilling prophecy.

Investors might decide their only real choice is to get on the euro express for fear it continues northwards without them.