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The European yields and the EUR exchange rate

Good morning!

Besides the bond market selloff that made the headlines over the past few weeks, another important development is the appreciation of the EUR by some 6.5% from its lows against the USD on the 13th of March. Prima face this could be attributed to higher long term yields in Europe and a decreasing gap relative to US Government yields.

However, the shortcoming of this argument is that yields alone do not explain the movement in currencies and to see this we can look at 2012-2014 period when EURUSD range traded despite an increasing gap between European and US yields. An even stronger example is provided by the Japanese Yen (JPY) which during 1998-2000 appreciated against the USD although the yield gap doubled during the same period to as much as 5%.

Sticking with Japan’s example, the missing piece in interpreting and anticipate exchange rate movements is the inflation and, more importantly the expected inflation. This is because a 5% yield in an environment where inflation is running at 4% is likely as good as a 1% yield in a 0% inflation scenario. For this reason, theory links currency dynamics to real yields which are calculated by deducting the inflation rate from yields. Hence the counterintuitive response of USDJPY during the before mentioned period to the higher yields in the US reflected the deflationary environment in Japan (i.e. falling prices).

Going back to Europe, over the last few weeks yields have increased but long term inflation expectations remained stubbornly low. Hence, the real rates increased, putting the appreciation of the EUR into perspective. If the trend in rates fails to reverse or inflation expectations fail to gather pace, there is thus limited scope for a return to a lower EUR.

Having said this, I am among those who say that a return to lower and negative real rates is necessary for the longer term growth outlook to improve. When yields are lower than the longer term inflation forecasts (i.e. real rates are negative) investors are gradually nudged to divest bonds and put money into other investments, which in turn helps growth. Most notably, banks have an incentive to downscale their government bond positions and in turn increase lending. If they fail to do so, their increase in margin won’t be enough to offset inflation and shareholders will be disappointed.

It should thus come as no surprise that the success of the last quantitative easing programme lunched by the Federal Reserve is partly explained by the persistency of negative real rates for several months in a row.

Note: In this analysis I refer to the rates and inflation expectations expected over 2020-2025 given that lending and capital spending decisions hinge more on the longer term outlook.

Have a nice day!