Seven reasons why the EUR may underperform expectations in 2021
A corollary of the market consensus for a weak US dollar in 2021, is that the euro will repeat last year’s strong performance. EURUSD rallied by about 10 cents last year – a similar performance would see EURUSD comfortably above 1.30 in 2021.
While I do have sympathy for the reflation / weak dollar thesis (see our 2021 Global Macro Outlook here), I remain unconvinced that the euro will be able to repeat its 2020 performance this year. There are seven reasons why I believe that a strong euro rally is not on the cards, even if the reflation thesis leads to a softer US dollar more generally.
1. Negative Carry
A key driver in EURUSD’s strong rally last year was the compression of the dollar’s nominal and real yield advantage over the euro. On a nominal basis, the US dollar’s carry advantage over the euro compressed by close to 80 basis points as the COVID crisis erupted in March. Since then, it has widened back out by about 25 to 30 basis points. While it is true that on a real (inflation-adjusted) basis the US dollar’s carry advantage is yet to return, it has managed to claw back the euro’s ‘real’ carry advantage from last year (see chart I).
Chart I: US 10Y Nominal Yield (solid blue), Euro 10Y Nominal Yield (solid orange), US Real 10Y Yield (dotted blue), Euro Real 10Y Yield (dotted orange)
2. Deflation Risk
Unlike the US, the euro zone is experiencing deflation. Since the middle of last year, the euro zone has been facing actual deflation as opposed to the disinflation experienced elsewhere. This is a real concern for the ECB, as deflation will increase the real value of debt burdens which are already above 100% of GDP in countries such as Italy, France and Spain. As a strong euro will exacerbate deflationary pressure by decreasing the cost of imports, expect the ECB to fight hard against a strengthening euro, especially if we begin approach 1.30 in EURUSD.
3. Political Risk
Any discussion on the outlook for the euro will inevitably touch on the political risks facing the European Union itself. The euro is as much a political construct as it is a currency, and its fate is inextricably intertwined with that of the political institutions which support it. Already in 2021, we have seen one European government fall (the Netherlands) and another on the brink (Italy). Add to this the imminent departure from the political stage of Angela Merkel, the closest thing that the EU has had to a ‘leader’ for the past decade, and political fallout from the European Commission’s apparent mismanagement of the COVID vaccine rollout (see below) and it appears inevitable that the political risk premium associated with the euro is set to rise rather than fall in 2021.
4. COVID Discount
As the market starts to look beyond the COVID crisis and begins pricing in expectations of a vaccine-led recovery, it is inevitable that the relative speed of economic re-opening will begin factor into asset prices, including FX rates. In other words, countries that vaccinate and re-open quickly and safely will have currencies that trade at a premium to countries which do not. As things stand, the euro zone looks to significantly underperform the US (and the UK) by this measure.
The UK has now administered ten vaccine doses per 100 residents, the US six, and the EU only two. The EU’s poor performance is linked to a variety of factors, including slower regulatory approval (the EU has still not approved the Astra Zeneca vaccine for example) and lower levels of funding (the UK and the US have both spent seven times more per capita than the EU on vaccine development, procurement and production).
The EU’s relative underperformance in the global vaccination race is likely to create a headwind for the euro in two ways:
- Delaying economic re-opening and slowing economic growth; and
- Increasing the political risk premium as noted above, as the EU is blamed for dropping the ball on this important and emotive issue, providing substantial political ammunition for populist anti-EU movements.
5. Vulnerability of Europe’s Current Account Surplus
A current account surplus is traditionally seen as a source of support for a currency. By exporting more than its imports, a country creates net demand for its currency. The eurozone has consistently been running a current account surplus since the euro zone crisis over a decade ago, which peaked at about 3.5% of GDP in 2018.
Since then, however, Europe’s current account surplus has been rapidly declining. During the COVID crisis last year, China supplanted Germany as the holder of the world’s largest current account surplus.
The deterioration of Europe’s current account surplus is likely to continue in nominal terms as globalization trends slow in the aftermath of the COVID pandemic. This is likely to drag on the euro directly (as there will be slowing demand for euros resulting from international trade) and indirectly (as the ECB will be even less tolerant of a strengthening currency as their international trading position is threatened).
Chart II: Eurozone Current Account as a % of GDP
6. FX Positioning
As I noted last week, the ‘short USD’ consensus is extremely strong, perhaps as strong as I have ever seen it. This is also reflected in market positioning. The current ‘long EUR’ position as implied by CFTC data (an imperfect but useful guidepost) is extremely stretched (see Chart III).
As highlighted in the chart, on the past four occasions where positioning has peaked, the EURUSD has sold off by at least 10 cents thereafter – albeit on once occasion with a significant lag of about a year.
Chart III: CFTC Speculative EUR Positioning (Black) versus EURUSD (Blue)
7. FX Valuation
While traditional FX valuation techniques based on purchasing power parity measures have limited predictive power over short (<two years) time horizons, they do have a decent track record over the long run.
As we noted in our 2021 Macro Outlook, last year’s euro rally effectively eroded the euro’s previous ‘fair value’ discount to the US dollar. The lack of a discount is not, in itself, a reason to sell the euro, but it does remove one of the more compelling reasons to buy.
Despite the overwhelming consensus that EURUSD will trade higher this year, the first month of 2021 has shown that this is not a one-way bet, with the euro slightly lower against the dollar year-to-date. While there are certainly reasons to be wary of US dollar risks, I still see the dollar’s vulnerabilities being expressed more visibly against other currencies. Despite outperforming the euro, the dollar is down against Bitcoin by about 10% so far this year!