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EUR/USD Whiplash: Fed Calls Time on USD Rally
The USD gives back its gains
The early 2020 dip in EUR/USD, to its lowest level since April 2017, did not prove to be the sustained break higher in the USD that some had anticipated, with the move aggressively unwinding over the course of the following week. The rush to close overweight USD positions helped drive the move, with the latest leg lower in the USD coming as a result of the intra meeting Fed rate cut.
There are several reasons why the USD had appeared relatively attractive coming into 2020. Of note, higher yields on US assets and negative rates in the eurozone enticed market participants into the carry trade. However, the coronavirus led to rising expectations of a Fed rate cut – which arrived on Tuesday (3 March), crushing carry and with it the appeal of the USD.
Investors had also been positioned for a stronger USD for reasons other than carry. At the start of the coronavirus outbreak, markets became convinced that the US was less economically exposed to China than Europe. This reinforced the market view that the USD was a safe haven currency. However, with the virus epidemic now spreading more rapidly outside of China, assumptions that it will have only a moderate impact on US growth have been cast aside.
Figure 1: Spread in 1-Year Forward 1-Month USD and EUR OIS
Source: Bloomberg Finance L.P., as of 3 March 2020.
The Fed as the driver
The gap between the 1-year forward of the 1-month OIS (Overnight Index Swap) in USD and EUR, a proxy for central bank rate expectations over the coming 12 months, has narrowed aggressively (Figure 1) and, at 117bp, is at its tightest since November 2016. The Fed may have delivered an emergency cut but markets remain priced for a further 75bp of easing by the end of 2020. Even if this proves overly aggressive, a rebound in the USD is far from given, for two main reasons:
- It looks unlikely that there will be a rush to reset long USD carry trades: these are for less volatile times.
- While economic weakness persists, investors are unlikely to favour the USD given that scope for the Fed to cut remains far greater than for the ECB.
The FX forward curve already prices a gradual appreciation in EUR/USD to over 1.1350 over the coming year (Figure 2) which, if realised, implies a drag of around 1.5% on USD portfolio performance for EUR-based investors.
Figure 2: Forwards Price a Rise in EUR/USD
Source: Bloomberg Finance L.P., as of 3 March 2020.
In conclusion, with the USD’s winning streak having come to such a dramatic end, EUR-based investors can no longer rely on a stronger USD to support asset market performance. For this reason, now may be the time to consider hedging USD exposures back to EUR. There are a suite of SPDR funds that offer the ability to hedge:
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