The euro-dollar exchange rate is the key to understanding international capital flows

day 14.09.2020 * Reading time: 10min.


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The euro-dollar exchange rate is the key to understanding international capital flows

The most important observations resulting from the analysis of the current situation:

Interest rates and the components of the money supply account for the recent depreciation of the dollar (quantitative easing), while the components of the current account and inflation have not yet been fully taken into account.

By combining the balance of payments with a monetary approach and assuming that the Covid-19 economic shock will subside in 2022 and US funding dynamics will approach pre-Covid-19 trends, the dollar could weaken by as much as 8% (~ 1.275) over the next 12 months.

As the dollar and euro are anchored at the short end of the curves by their respective central banks, the EUR/USD forward rates do not contain any significant information about the future path of the EUR/USD exchange rate.

Personally, for Eurodollar estimation, I prefer a structural basic balance measure that takes into account the current account, direct investment and statistical discrepancy – a good EUR / USD ratio in the medium to long term.

After peaking on March 20, 2020, the dollar lost 10% against the euro (1.174 on September 21, 2020), returning to levels most recently seen in mid-2018. This sharp depreciation has raised many questions about the future of the dollar. When trying to forecast a currency exchange rate, a traditional and widely used approach is to look at the forward currency markets. In theory, this approach makes a lot of sense as it shows at what price you can hedge your future exposure to EUR/USD across different time horizons. However, does the forward price contain significant information about the future path of the EUR/USD rate? Historically, the prognostic power of the EUR/USD futures market, especially in the short term, is very limited. It is enough to compare the implied spot forward rate with the realized spot rate to see that the estimate is inaccurate not only in level but also in direction most of the time.

Chart: 1-year EUR/USD forward contract

Source: Refinitiv, RCieSolution Research

Why is this happening? Most market makers use the non-arbitrary interest rate parity method (or a similar method) to pricing forward contracts.

From the above formula, it can be concluded that using such a methodology, on the right side of the equation (in blue) are the expected economic forecasts 1 year in advance for both the US and the European Monetary Union (EMU) countries. It is a representation of the interest rate difference between two countries/regions.

Chart: EMU – UST 1-year USD interest rate differential versus 1-year EUR/USD FWD

Source: Refinitiv, RCieSolution Research

However, the value of the equation on the right changes very slowly when dealing with currencies from developed markets (eg EUR, USD). This figure can become extremely important in emerging market currencies as differences in their interest rates can be very volatile. In the case of EUR/USD and in the current context of “lower for longer” short-term rates, the right side of the forward equation is likely to remain anchored and follow the pseudo-constant type of behavior in the near future. In this context, the above-mentioned forward pricing formula is likely to be:

𝐸𝑈𝑅𝑈𝑆𝐷 1𝑦 𝐹𝑜𝑟𝑤𝑎𝑟𝑑𝑡 = 𝐸𝑈𝑅𝑈𝑆𝐷 𝑆𝑝𝑜𝑡𝑡 ∗ (~ 1,015)

Therefore, the annual forward price is and will be determined solely from the current spot price, meaning that there is no relevant information embedded in the EUR/USD annual forward price as long as the annual interest rate differential remains locked by both the Federal Reserve and the ECB.

Balance of payments approach

By adopting this approach to supply and demand, we are able to see how much US dollars are offered to the rest of the world and who is buying them. At the basic level of the balance of payments (level 2), whenever the purchase of a foreign asset or the sale of a domestic good abroad is recorded in the balance of payments, it implicitly means that there is a change in the demand for or supply of foreign currency. In other words, an international transaction cannot be completed if one of the parties to the transaction is unwilling to exchange its domestic currency for a foreign currency.

With this in mind, and in line with the modeling used, the most significant components of the balance of payments that have a direct impact on the EUR/USD price discovery are direct investment, portfolio investment and the structural core balance, as they affect the dollar-denominated cash supply and are volatile. more than the current account level.

On the basis of the relation of direct investment to EUR/USD, it can be concluded that the current EUR/ USD levels are not fully consistent (they are too low) with the inflow of direct investment that the United States has experienced over the last four years. From this long-term relationship, it can be concluded (subject to changes in Q2 2020 data) that unless we experience a massive structural drop in inflows over an extended period of time, the continued inflow of direct investment to the US should support the dollar in the medium and long term.

Similarly, but with less accuracy, portfolio investment flows tend to coincide with movements in EUR /USD. In this context, and assuming that the US economy in the medium and long term will accelerate faster than its neighbors, it can be concluded that this expected inflow of investment capital may support a stronger dollar. While portfolio transactions are long-term in nature, they are potentially very volatile as nothing is easier to trade than a US Treasury bond. In this context, if there were a structural shift in the perception of the US economic situation compared to the rest of the world, this source of funding would undoubtedly slow down.

The structural measure of the basic balance, which takes into account the current account, direct investment and statistical divergence, has proved to be a good predictor of EUR/USD movements in the medium to long-term trend, which tends to herald peaks and falls in the exchange rate (partly because it reflects changes in the direct investment):

Structural Basic Balance = Current Account + Direct Investment + Statistical Discrepancy

Rafal Ciepielski

Rafal Ciepielski

CEO RCieSolution

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The views expressed in this document are not research, investment or commercial advice, and do not necessarily reflect the views of all management teams. They change over time.