All of a sudden, everybody is talking about the euro.
The currency has risen 8% against the U.S. dollar since July 9, when selling induced by Federal Reserve chairman Ben Bernanke's June 19 press conference — in which he hinted at tapering quantitative easing, causing strength in the dollar — culminated.
Today, the euro trades just below $1.38.
Steven Englander, global head of G10 FX strategy at Citi, just returned from client meetings in South America, and he said the thing everyone was asking about the most was the euro.
"The bulk of questions received were on EUR/USD, and our views were into year end," he writes in a note. "Most clients were happy to see it lower, but conviction was low as to the timing of the move. Views for significant EUR/USD upside were again also limited. Several accounts were buying EUR/USD presently, but discussions of the trade tended to lack medium-term justifications, although several clients cited technical reasons. The dominant view was EUR/USD could rise to 1.40, although investors in European assets were looking to establish hedges on their underlying exposure."
Société Générale global head of economics Michala Marcussen also says the number-one question from her clients is about the euro.
In a note, she writes:
TOP CLIENT QUESTIONS
WHY IS THE EURO SO STRONG?
Investor inflows is the most common answer
Hitting a two-year high against the U.S. dollar last week of just over $1.38, euro strength appears to be defying the traditional fundamental explanations of the relative monetary policy stance, external balances and growth differentials. Foreign investor inflows - attracted by abating tail risks, attractive valuations and green shoots of recovery – now appears the most common answer. There is an obvious, if undesirable, self correction mechanism to this logic, should foreign investors ultimately be disappointed by the euro area recovery. A scenario that becomes more likely, the longer euro strength continues.
SocGen global strategist Kit Juckes penned a note in response to Marcussen's, expanding on the reasons for the higher euro:
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I have been bandying around ultra-simple two-factor models of EUR/USD for a while. They help me to think about what kind of currency move I can expect from the two big drivers of the euro’s fortunes – rate spreads, and risk aversion as shown by the 3-year Spain/German spread. The one below suggests that if the 'neutral' Spain/German spreads is 200 basis points, and 2-year swap rates are identical in the U.S. and euro area, EUR/USD will be at 1.34.
That 'feels' high to lots of people, but when you run a current account surplus and employ a central bank in which Germany has a voice, it's what you get. Today, we are at 1.38, about 1% above the simplistic 'fair value'. The reason the fair value is so high is that 3-year Spain/German spreads have fallen to 165 basis points, the lowest level in 2 ½ years, and 2-year euro rates are above U.S. ones. This is 'why' we are here.
Juckes says the reason this caught everyone off guard is that "we didn’t expect that the market would be more hawkish about ECB than Fed policy at a time when the euro area economy is barely growing, nor did we expect to see the endless grind of Spanish bond out-performance go quite this far."
In the week ended October 23, investors poured $5 billion into European equity funds, marking the biggest weekly inflow ever into the asset class.
These funds have seen nothing but inflows for the past 17 weeks — since the beginning of the second quarter, when PMI surveys suggested the eurozone was finally emerging from recession.
Investor sentiment toward eurozone assets seems to have been spurred by recent improvements in the currency bloc's economic picture.
"Why won't the euro go down when everyone says it will?" says Neville Hill, head of European economics at Credit Suisse. "The euro area's current account has skyrocketed to a record 2.5-3% of GDP...we think that's why euro shorts are consistently disappointed!"
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