Today's edition of the Saxo Morning Call features the SaxoStrats team discussing the continuing weakness of the US dollar as commodity prices recover ground and in the wake of key US equity indices hitting all-time highs Thursday.
Article / 18 December 2017 at 23:04 GMT

ECB considers impact of EURUSD rising to 1.36

Managing Director / Technical Research Limited
New Zealand

  • ECB analysts have conducted sensitivity analysis around EURUSD
  • There is absolutely no tolerance for a rise in the value of the EUR
  • FX basis blowout should be watched over year end

By Max McKegg

A couple of weeks ago Saxobank analysts posted videos of their “Outrageous Predictions” for 2018, always a thought-provoking and entertaining watch.

One of the predictions was a big call that EURUSD will drop to parity as the Austro-Hungarian empire threatens the EU. 

But what if it was to move just as far in the opposite direction ? 

The European Central Bank doesn’t make predictions, let alone outrageous ones. They publish quarterly baseline “projections” that assume the oil price will move in line with the futures curve and the exchange rate will flat-line at the current rate throughout the forecast period. 

Behind the scenes, Euro-system staff analysts do a “sensitivity analysis” around market pricing of key variables, based on option pricing, and publish it as part of their December macroeconomic projections for the euro area. 

Accordingly, last week’s publication looked at a situation where EURUSD, instead of flat-lining out to 2020, rises to 1.3600. 

Not an outrageous prediction. Indeed, not a prediction at all, but a “scenario”. It’s worth noting that in previous post-GFC reports the the sensitivity analysis was always modelled on the assumption EURUSD would decline over the projection period because of “diverging monetary policies” between the US and Eurozone. 

Have ECB officials got their models in a muddle over EUR projections? Photo: Shutterstock

The staff could have stuck with the script this time around but didn’t. Perhaps they have belatedly noticed that rate differentials have not held back EURUSD this year and that diverging monetary policies are not the only factor at play. 

For its part, the ECB Governing Council says the Euro-system staff projections are an “input” into their assessment of economic developments but are not “endorsed” by the council. 

Nevertheless, last week’s post meeting statement said, as usual, that the staff projections “broadly reflect” the council’s view.

The analysis has EURUSD rising gradually to 1.3600. 

As shown in the chart below the exchange rate has been trading in a narrow range for the past three years and volatility has hit multi-year lows. 

Few analysts would have 1.3600 on their radar. As an aside, a similar chart pattern broke that way in 2002. 

EURUSD yearly chart (click to enlarge)
Source: Metastock 

All else being equal, EURUSD at 1.3600 would not be acceptable to the ECB, because, as shown in the chart below, their latest core inflation projection falls short of the 2% target. 

And the projection assumes EURUSD will hold at 1.1700 throughout. What would happen if it rose to 1.3600? 

The staff scenario analysis gives us the answer: core inflation at 0.9% in 2018; 1.0% in 2019: 1.2% in 2020. 

The ECB wouldn’t wait around for this to become reality. If EURUSD beings the new year on an upward path consistent with the scenario, alarm bells will start ringing. 

Monetary policy would need to be tightened in response, perhaps when updated economic projections are released next March. 

Note that the analysis only applies if the exchange rate rise is an “exogenous shock”, that is, caused by factors not related to economic conditions in the Eurozone. 

That would be the case if, for example, the USD were to fall because the Fed was backtracking on monetary policy normalisation. 
xxx Source: Nordea 

But that’s next year’s story. In the short term EURUSD has storm clouds forming over it due to the blow out in the cross currency basis swap. 

The basis is the extra cost of hedging in addition to the interest rate differential, caused by a supply and demand imbalance for USD funding. 

At the moment there is high demand for US dollars, in part because of worries that US tax reforms will lead to the repatriation of up to $4 trillion. 

The basis often blows out at year end as banks balance their books. Usually it recovers early in the new year. 

But if it doesn’t this time we could see upward pressure on USD (and therefore a lower EURUSD).


Source: Wall Street Journal 

Here’s an example of the cross currency basis swap in action.

A Eurozone-based investment fund wants to buy relatively high-yielding US Treasury bonds. 

To eliminate FX risk, the fund manager needs to enter into a cross currency swap to borrow USD and lend EUR. 

With 3 month USD Libor at 1.6%, eurolibor at -0.35% and the basis around 100 basis points, the total cost of hedging is 3%, give or take. Effectively the investors pays 1.6% to borrow USD but earns –1.35% on the euros lent. 

The yield on the 10 year US Treasury bond is 2.35%. But if the cost of hedging is 3% then the investor ends up with a negative return, as shown in this chart.

Source: Bloomberg 

In pre-GFC days, bank arbitrage desks would have ensured the cost of borrowing USD in the FX markets was the same as Libor, as per the law of interest rate parity. 

But balance sheet restrictions mean they now have to be judicious in adding derivative exposures. That leaves to door open for financial institutions with access to USD funds - central banks, sovereign wealth funds and big US investment companies - to lend those dollars through the FX market and make a handy return. 

In the above example these fund managers are able to lend USD and borrow EUR at –1.35%. Those proceeds can then be invested in short term euro-denominated securities to give a positive return. 

The ECB sensitivity analysis around its latest macroeconomic projections is not a prediction as such, but it does suggest the bank sees upside risk to EURUSD. 

With inflation expected to remain below target out to 2020, there will be little tolerance for the exchange rate embarking on an upward trend, thereby compounding the shortfall. 

But in the short term the cross currency basis may weigh on EURUSD.

 -- Edited by Adam Courtenay

Max McKegg is managing director of Technical Research Limited. If you would like to receive all Max’s Daily FX Trading Forecasts, then you are welcome to contact him here

Michael O'Neill Michael O'Neill
Excellent article, Max.
Max McKegg Max McKegg
Thanks Mke
TheNomad TheNomad
Balancing is done, Holiday started for MM desks. First sign of relief on EUR happened this Monday
Jon O.Tufta Jon O.Tufta
Hih Max..interesting article.If a european investor long of euros wants to buy Us Treasury paper..why not just do the swap and you have dollars to invest..with cost around 1,95 %.If you want to sell the US paper again simply do the other side of the swap..and you are back in euros?
Old dealer from Norway
Romanatrader Romanatrader
Hi Max, good article...
Patto Patto
Jon. I agree with Max's calculation. The cost of dollars would indeed be 1.95% thru an FX swap but only if the basis was zero. It isn't: it's another 100 bp.
TheNomad TheNomad
Old news and back to earth
Federigo Federigo
This comment has been redacted
kalish kalish
I don't get the part where US investors make a handy return, since yes, they would make a handy return, but no european manager would buy us treasuries. So...?


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