How the Euro Became Decoupled From the Price of Assets
In recent weeks, rhetoric seems to have politicized the valuation of currencies. This is especially true in Europe, which has experienced a notable divergence between the performance of the bond market and that of the euro. In a year of elections in the Netherlands, France and Germany that could usher in a large sweep of populist parties to parliaments, the decoupling between the euro and European asset valuations has several implications for investors.
The first notable difference is between the euro spot exchange rate and peripheral bond spreads. During the European debt crisis from 2010 to 2012, the relationship between the decline of the euro and widening bond spreads was always very close. This was the result of capital outflows from foreign investors who exited European bonds out of fear of “redenomination risk,” as well as the conversion of euro currency back to local currency (such as Italian lira or Greek drachma).
Today, this relationship is decoupled (Fig. 1). One reason is the European Central Bank’s presumptive “tapering” announced in December 2016 that put a bid under the euro. That bid was further cemented by recent commentary by U.S. President Donald Trump’s trade adviser Peter Navarro pointing to a “grossly undervalued euro exchange rate.” The bond market faces pressure that is visible in the widening of Italian and French spreads to Germany to four-year highs. The widening of spreads has been caused by ill-timed ECB tapering of quantitative easing, along with Marine Le Pen’s pledge to remove France from the euro and growing concerns of a spreading non-performing loan problem in Italy. But unlike in 2012 and 2015, when Greece’s new government threatened to exit the monetary union, the euro is not facing a redenomination risk stemming from Italy or France.
The second notable difference is apparent in the “term structure of FX volatility." This is volatility expressed by different maturities. The euro shows a “hump” in the volatility term structure around two to four months from today, when the Dutch and French elections heat up. On the other hand, the term structure of forward rates for euro structure of forward rates suggests the currency will be stable to stronger for at least a year. That means the market has assigned little risk premium to the euro in terms of an adverse election outcome, even though currency volatility discounts a greater risk of a populist upset.
The French and Italian economies and bond markets combined are 20 times larger (4 trillion euros) than the Greek economy. Thus any significant change in the Italian and French political spectrum in terms of a populist majority government would not only pressure bond spreads but also the euro.
That view might be most visibly expressed in real interest rates. Fig. 3 shows early 2012 real interest rates were negative and the euro was trading at high levels. This was immediately before the Greek debt restructuring and subsequent elections and the Spanish banking troubles in the spring. Today, although the euro trades at a lower level, the same combination exists: a strong euro while real rates are very negative. Any risk of a populist outcome in this year’s elections may result in a worse combination of rising real interest rates and a falling euro as in 2012. The bond market is already on alert for this possibility, but the euro is not. Investors should discount a great currency risk premium when valuing European assets. If done properly, post-Dutch and French elections potential dislocations may offer more attractive European valuations than today.
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