A surprisingly strong US economy – a surprisingly weak euro. How will we be surprised in 2015?
Among the biggest surprises in 2014 was the decline in long term interest rates in Europe and the US. Another surprise for the market consensus in mid year was the strength of the US dollar and the weakness of the euro.
These two surprises were not unrelated. The decline in long term rates was led by European fears of deflation. US rates essentially followed the European lead lower, even as the US recovery gathered strength and expectations that the Fed would raise its target rate in 2015 firmed. But the decline in US rates lagged behind those in Europe and so the spread between these rates widened. We illustrate this in the charts below where we compare 10 year US Treasury and German Bund yields and show the generally widening spread between them.
Thus, despite persistent US dollar strength vs the euro and almost all other currencies from mid year, when the euro traded at close to US$1.40, the case for borrowing euros to lend dollars became ever stronger. Presumably the extra rewards for holding dollars rater than Euros added to the demand for, and the strength of, the US dollar.
The spread itself indicates that the market expects the US dollar to weaken against the euro, according to the theory of interest rate parity. Arbitrage makes the cost of forward cover equal to the difference in interest rates. If this were not the case riskless profits could be realised by simultaneously borrowing or lending in the one currency and buying or selling the currency in the market for forward exchange. The higher rates in the US are meant to compensate the lender of dollars and the borrower of euros for the expected weakness in the US dollar, thus making it a matter of indifference to a currency hedged borrower or lender in which currency a financial contract is written.
The recent strength of the US dollar, despite expected weakness, therefore represents an unambiguous surprise for the market. Yet it is difficult to predict a reversal of these exchange rate trends when the yield spread in favour of the US dollar remains as wide as it is or especially should it widen further. Unexpected strength in the US economy will help keep up US rates relatively to euro rates and the spread will encourage dollar strength, as has been the case in 2014. An unexpectedly weaker European economy will do the same: keep rates lower for longer in Europe as deflation takes hold and so add to US dollar strength and euro weakness.
The direction of the spread will tell us whether the market place has been too bullish or bearish about the US economy and too bearish or bullish about the outlook for the European economy. This key indicator will deserve the closest attention in the months ahead. If you believe the US economy will surprise on the upside, then buy dollars. If you believe Europe will surprise with better than expected growth, then sell the US dollar.