This month’s ECB meeting made it crystal clear that the central bank isn’t deviating from its hawkish monetary policy stance to tame the ongoing inflationary pressures. Given growth has been surprisingly resilient thus far and with foreign inflows into Euro area assets gaining traction in recent months, investors seem to be turning more constructive. The near-term setup supports the case for further EUR/USD upside – in addition to the planned fiscal stimulus (vs. the political hurdles facing US fiscal support), Europe is also more levered to the China reopening theme. Plus, the ECB doesn’t have the same price stability vs. financial stability tradeoff faced by the Fed, allowing for a steeper tightening path ahead (via rate hikes and quantitative tightening). With all signs pointing to higher euro area sovereign yields and superior carry this year, the EUR/USD rally likely still has legs, in my view. For investors looking to express a bullish EUR view, the Invesco CurrencyShares Euro Trust ETF (NYSEARCA:FXE), which tracks the EUR/USD for a 0.4% expense ratio, is a no-hassle alternative worth considering.
Monetary Tightening Runway Diverges Amid Ongoing Bank Stress
The EUR has outperformed the USD in recent months amid continued ETF inflows, though concerns about the health of Euro area banks following the US banking failures and the Credit Suisse (CS) takeover have emerged as an overhang. In the fallout, the likes of Deutsche Bank (DB) have seen its stock sell down significantly amid worsening investor sentiment. Compounding the confidence crisis is a lack of visibility into the state of banking deposits, which could fuel more uncertainty and a prolonged risk-off stance by investors. The ECB and Bundesbank officials have done their part for now, reassuring markets of their willingness to act, and this has been reflected in resilient EUR/USD performance through the ongoing European banking concerns.
Net, I think the differing context on the state of the US/Euro banks is important – unlike the US banks that failed, European banks have a much different asset-liability profile, with ‘stickier’ household deposits making up a significant ~30% of their liabilities. Another key difference is the more liquid reserves held by Euro area banks, with a much smaller percentage of assets invested in rate-sensitive bonds.
Finally, small and medium banks, which are perceived to be more vulnerable, have less of a presence in Europe and are more likely to be merged in an unlikely scenario where they suffer bank runs. The more pertinent concern, in my view, is the state of their domestic economies, given euro banks’ books are more exposed to household loans and are, thus, more vulnerable to default risk on rate-sensitive sectors like property. For now, any concerns here seem overblown, given overall NPL levels remain well below prior periods of banking stress.
The Turnaround in Portfolio Flows to Continue in EUR’s Favor
Data from recent months show ETF inflows into the Euro area are accelerating – following five consecutive months of inflows, YTD data indicates the positive run rate remains intact. Of note, the inflows coincide with the EUR/USD rally and, perhaps most importantly, with China’s reopening, highlighting Europe’s higher beta to China trade activity relative to the US. Also worth noting is that the EUR rally has tracked the more constructive services-led turn in recent months’ Euro area PMI data, with the latest composite PMI coming in particularly strong at ~54 (i.e., an indicator of expansion).
Alongside the flow tailwind, the ECB’s relatively longer monetary tightening runway is key to continued EUR strength. Beyond rate hikes, the ECB’s quantitative tightening program (QT) has gone into full swing this month – following a controlled EUR15bn/month run-rate to start, the pace of the balance sheet run-off is set to accelerate into mid-year to a peak of ~EUR20bn/month. Given QT will involve the ECB’s sovereign bond portfolio, European bond yields should move upward in tandem, fueling a stronger carry for the EUR. Also key to EUR/USD strength is the diverging price and financial stability tradeoff between the ECB and the Fed, allowing it a longer runway to tighten financial conditions. Assuming growth remains intact, all signs point to higher rates, particularly at the front end, which should support a reflexive rebalancing into euro area assets and keeps EUR downside capped for the coming months.
The EUR Recovery Might Just be Getting Started
Following prolonged EUR/USD downside over the last two years, the setup for a stronger EUR appears compelling. For one, the relatively longer tightening runway for the ECB is a key factor – not only because of the higher inflationary pressures in the Euro area but also because its monetary policy isn’t constrained by a financial stability tradeoff (unlike in the US). The latest ECB rate meeting confirmed the hawkish tone, with Lagarde committing to more tightening to tame core inflation. Investor sentiment has begun to turn as well – foreign ETF inflows are accelerating on hopes of the Euro area avoiding a recession (or getting away with a shallow one) amid more fiscal stimulus measures and benefits from the reopening of China, the EU’s biggest trading partner pre-COVID. Net, the path is clear for a steeper tightening policy and higher Euro area yields, which bodes well for EUR upside. For investors looking to ride the EUR/USD trade at a reasonable cost with no hassle, FXE is worth a look.