20 May 2021
The recovery in Europe has been lambasted for trailing the US rebound, but the gap has now narrowed, which should bode well for the euro.
The vaccine rollout in Europe, while initially criticised for a slow start, has picked up significantly; in fact, European vaccination rates are currently outpacing the US rate. European growth and activity levels vs. the US are also now on a solid footing. We believe this catch-up should materialise in the currency market more than in the rates market. While European rates have been gaining ground on the US, they are predominantly driven by monetary policy. A key driver of monetary policy is inflation, which economists expect to drop off meaningfully later this year in Europe, largely due to base effects. As such, we expect the European Central Bank to maintain its easy policy stance for the foreseeable future. In the US, however, April’s Core consumer price index print reached 0.9% month on month, the highest upside surprise since 1982. While the Federal Reserve (the Fed) will continue to focus on the more persistent factors, inflation pressures are looking more realistic in the US than in Europe, which could drive differing monetary policy approaches and keep rates more anchored in Europe. In terms of the upshot for currency markets, assuming the Fed maintains its dovish stance, the euro should continue to grind higher vs. the US dollar as US real yields remain very low and the US grapples with poor longer-term fundamentals, specifically the twin deficit posed by its current account balance and federal budget balance.
The move in interest rates in Europe has been fairly significant since the acceleration of the vaccine rollout: German 10-year Bund yields have risen from -0.29% at the end of March to -0.10%. At the same time, the difference with the US 10-year yield has narrowed from 2.03% to 1.74% over the same period. Currency markets have also started to price in a convergence in the vaccine rollout and economic recovery, with the euro gaining 4% against the US dollar, moving from 1.17 to 1.22. While the lack of persistent inflation in Europe suggests that the rates move may have largely played out already, we have confidence that so long as there are no setbacks in Europe the momentum in the euro’s strength should continue to build given both weak US dollar fundamentals and supportive euro technicals. (Data as of 18 May 2021).
Markets are pricing in a convergence in the recovery between Europe and the US
The euro is supported by a positive backdrop of cross-border flows as foreign investors look to convert their cash to euros in order to buy European assets and begin to position for a regional recovery. Our internal flow monitor suggests that European equities, for instance, have witnessed inflows of over EUR 10 billion so far this year (equivalent to 2% of AUM) with almost half of that coming so far in May (as of 18 May 2021).
What does this mean for fixed income investors?
With accelerating vaccinations and a strong political will to reopen for the summer tourist season, restrictions should ease in the coming weeks in Europe and investor sentiment is likely to improve. This has been clear in the convergence between Europe and the US in both the interest rate and currency markets. However, it is fair for investors to remain sceptical that European interest rates can continue to close the gap with the US at the same pace; inflation is expected to drop in Europe, whereas the US just released blockbuster inflation figures, although the Fed’s belief that the inflation is transitory suggests it will not start normalising rates just yet. The recovery should still boost the euro as fund flows head towards Europe and the US dollar remains challenged by its fundamental headwinds.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum