Forget ‘Euroglut’ – low rates no recipe for weaker currency

LONDON (Reuters) – Conventional market wisdom holds that higher interest rates strengthen a currency, and lower rates weaken it. But the euro’s recent run and the historical performance of the yen and Swiss franc show it’s just not that simple.

Since the euro’s inception in 1999, by far the strongest of the world’s 10 major currencies has been the Swiss franc, which has had comfortably the second-lowest average interest rate over the period.

Having by far the lowest average interest rate over those 17 years hasn’t hampered Japan’s yen too much either. The yen has come to symbolize the ultimate funding currency in which to borrow for higher-yield investments, or “carry trades.” But it has outperformed three of the 10 majors over that period and is only narrowly behind the dollar and euro.

This brings us to the euro, which last week hit its highest level against the dollar in over a year. Its resilience in the face of super-loose monetary policy and negative interest rates from the European Central Bank has forced the large pack of euro bears to throw in the towel, most notably Deutsche Bank.

In October 2014, Deutsche coined the term “Euroglut,” shorthand for the ECB driving euro-zone yields so low that the continent’s huge surpluses would be funneled into markets overseas, driving the euro sharply lower.

Excess savings, aggressive ECB easing and scant investment returns would lead to “some of the largest capital outflows in the history of financial markets,” Deutsche said back then.

For a while, it followed that pattern. The euro, which had been nudging $1.40 only five months before, was at $1.26 and hurtling lower on its way to under $1.05 in March the following year.

As the ECB pushed interest rates deep into negative territory and ramped up its quantitative-easing bond-buying stimulus, currency speculators amassed the biggest bets ever against the euro, and much of the bloc’s nearly €700 billion current-account surplus over 2015 and 2016 was recycled abroad.

A break below parity and further weakness looked inevitable.

But it didn’t happen. The trade-weighted euro bottomed out, and speculator bets on it falling maxed out in early 2015. Last week, it nudged $1.15 against the dollar, and Deutsche Bank abandoned its sub-parity forecast.

Deutsche Bank’s George Saravelos says “Euroglut” wasn’t a theory about the exchange rate as much as a description of the euro zone’s balance of payments in recent years. As the ECB eased policy aggressively, that balance deteriorated from being strongly positive to a record negative, and the euro slumped accordingly, he notes.

The euro’s subsequent failure to fall further is more a consequence of dollar-positive drivers, such as more US rate hikes and tax cuts, not materializing, he adds.

YOU SAY HIGH, I SAY LOW

But low inflation, low interest rates and large domestic surpluses – pretty much the euro’s ecosystem in recent years – are often ingredients for a strong currency, not a weak one.

Countries with structurally low inflation, balance of payments surpluses and high domestic savings don’t need high interest rates. Over time, inflation and capital flows determine exchange rates, not short-term rate differentials.

Since the euro’s launch in January 1999, the best-performing G-10 currency is the Swiss franc, and the worst is sterling. Swiss inflation and interest rates have averaged 0.49% and 0.90%, respectively, and Britain’s 1.98% and 2.81%, respectively.

The Swiss franc’s nominal broad effective exchange rate is up 49% in the last 17.5 years. The country last ran a current-account deficit in 1980, which shows the structural support the franc enjoys, and its surplus has averaged around 10% of gross domestic product since 1999.

It takes substantial investment or portfolio outflows to overturn such persistent demand for a currency.

Japan also last posted a current-account deficit in 1980, and its average annual surplus since 1999 has been around 2% of GDP. Japanese interest rates since 1999 have averaged 0.17% and inflation precisely zero.

The yen’s nominal broad effective exchange rate is up a modest 5% since 1999. But that’s more than the Swedish and Norwegian crowns, which have boasted average interest rates of 1.96% and 3.15%, respectively.

Japanese and Swiss policy makers have spent years trying to push their currencies lower through the loosest monetary policies in the developed world. Longer-term fundamental forces, however, show it’s just not that easy.