Euro’s rally might receive a further boost
A snowball effect: Euro to strengthen against Pound Sterling as Eurozone investors are forced to hedge against an unexpected strengthening of their currency.
Analysts at BNP Paribas have warned their clients that the Euro’s rally might receive a further boost as Eurozone investors start to hedge their exposure to global investments against losses from a rising currency.
The Euro’s ongoing rally might still be young with a growing consensus amongst the analyst community that the single-currency still has more gains to offer.
In short, when the value of the Euro rises, the returns on international investments for those investors living in the Eurozone diminishes and they have to buy exposure to a rising Euro to offset any currency-inspired losses.
It would appear that the investor community was not expecting the Euro to rise as agressively as it has and by hedging they could now play a greater role in exacerbating the move.
The news will disappoint those looking for a stronger Pound from which to conduct international payments in Euros – the GBP/EUR has fallen from a 2017 high near 1.20 in early May to the 1.11s seen at the time of writing.
According to Sam Lynton-Brown, an FX Strategist with BNP Paribas in London, since the start of the ECB’s QE, Eurozone investors have bought large amounts of foreign bonds, likely unhedged.
“We estimate these positions were, on average, put on when EURUSD was around 1.12 and so are now making a loss,” says Lynton-Brown, “the hedging or unwinding of the stock of foreign bond holdings would lead to substantial EUR buying.”
In short, investors will look to buy EUR/USD to counteract any losses they would incur on foreign investments owing to an appreciation in the Euro which is clearly underway.
The call comes at a time of impressive Euro outperformance; the Euro remains the darling of the global foreign exchange trading community with fresh data confirming traders continue to add to their bets for further Euro strength.
“We now forecast EURUSD to rise to 1.30 by end 2019; but there is a risk that eurozone repatriation flows result in a faster rise,” says Lynton-Brown.
The catalyst for an acceleration of Euro gains could come from Eurozone investors hedging away FX risk on their stock of foreign bond holdings built up during the European Central Bank’s quantitative easing programme.
According to ECB balance of payments data, Eurozone investors bought EUR 1.06trn worth of foreign bonds in the period October 2014 (three months before the ECB announced its QE programme) to May 2017.
Eurozone investor flows into foreign debt markets are a reflection of the eurozone’s large current account surplus and the extent to which ECB QE has encouraged flows into foreign bond markets.
“These flows have therefore likely resulted in a very large short EUR exposure being held by eurozone investors. These positions themselves do not suggest that the EUR should continue to rise from current levels, but the potential for large buying flow can be thought of as a Sword of Damocles overhanging bearish EUR views,” says Lynton-Brown.
Pound Sterling Forecast to be Undermined by Bank of England
While the Euro’s outlook is positive, the same can’t be said for Sterling and BNP Paribas maintain the view that conditions remain in place for GBP/EUR to experience further pressure.
The immediate risk for Pound Sterling is the Bank of England who deliver an important policy update in the first week of August.
The August policy decision will be delivered alongside the release of the Bank’s latest set of economic forecasts – these meetings are often referred to as a ‘Super Thursday’ event for the Pound.
Most analysts don’t expect the Bank to raise interest rates but warn the communication from the Bank might prompt a great deal of volatility in Sterling.
The Bank currently forecasts growth of 1.9% for 2017, “which is too aggressive in our view,” says Lynton-Brown.
BNP Paribas forecast growth to come in at 1.5%.
“We think downward revisions to its forecast are therefore likely, and should weigh both on rate hike expectations (the market currently prices a 40% chance of a 25bp rate hike by November) and on the GBP,” says Lynton-Brown.
While the Bank’s Monetary Policy Committee will likely retain a bias to hike, BNP Paribas think growth underperforming versus the Bank’s expectations will ultimately prevent them from doing so until late 2018.
BNP Paribas are forecasting the Pound to Euro exchange rate to end 2017 at 1.11 ahead of a recovery towards 1.1236 by the end of March 2018.
However, as noted there is the chance of a hefty overshoot if the Euro does in fact rocket higher against the Dollar which remains a key risk.
May says Free Movement of EU Nationals to End in 2019
Some significant news on the final day of July – Theresa May has ruled out the prospect of the free movement of EU nationals in and out of the UK from March 2019 onwards.
A statement from May’s office confirmed free movement will “end in March 2019.”
There had been speculation that the UK would enter a transition deal with the EU for a period of at least two years on Brexit in order to provide certainty for business. Such a deal would see the UK stay in the customs union and single-market.
We, and many commentators view the transitional deal as being absolutely key for Sterling’s outlook as it guards against a cliff-edge and chaotic exit and provides businesses with the certainty required to make investments and keep the economy moving forward.
However, free movement of EU nationals would be a key concession to getting such a deal – the EU will not allow single-market membership if their citizens are not allowed to move freely across the UK border.
The move by May puts her on the side of the ‘Hard Brexiteers’ such as Liam Fox and David Davis and sets her up against her Chancellor, Philip Hammond who appeared to be winning the debate on seeking a transitional deal.
This is a significant – and negative – development we feel.
The question is, why does Pound Sterling not take the same view? It is virtually unmoved.
Source: PoundSterling – “Substantial Euro Buying” Ahead as Eurozone Investors Hedge their Investments
