The Case for a Higher EUR

Real yield differentials will become increasingly important for FX markets, but there are two ‘types’ of real yields to study.

One is driven by risk premiums often seen in high-yielding currencies and the other by falling inflation expectations. In countries where the idiosyncratic stories are improving, risk premiums have started to decline, as funds seek yield within an otherwise lowyielding world. In this context, we believe BRLMXN has further upside unless global risk appetite turns abruptly from here.

JPY guidance. Despite many equity markets recouping post-Brexit losses, global bond yields have stayed offered with weak inflation expectations and increasing global savings working as the catalyst. We see an increasing risk that the EUR will trade more like a ‘mini-JPY’, benefiting from inflation expectations falling faster than nominal yields, pushing real yields up.

Asia’s deflation. The evolution of inflation rates seems increasingly driven by global factors. Seeing oil prices doubling without inflation expectations responding positively suggests that there must be other factors overwhelming the inflationary energy impulse. The overcapacity in AXJ seems to release a good dose of deflationary pressure, impacting inflation globally.

RMB declines. The PBoC has expressed its commitment to ‘RMB stability against the basket’. Nonetheless, the RMB-TWI is depreciating at a 11.5% annualized rate, mainly against the EUR and the JPY. Should the RMB maintain its recent trend, the EUR and JPY may receive another boost via real rates. However, the more these currencies appreciate, the bigger the global asset risk, in our view.

Brexit. Currently, markets treat Brexit as a local European event, sizable enough to keep the Fed cautious but not challenging EM’s growth outlook meaningfully. We watch European banks’ shares falling as low rates undermine leveraged-based business models. At some point, falling equity prices could lead to asset repatriation, pushing the EUR up and GBP down.

Israel.The Bank of Israel has flagged the currency as a tool to reflate the economy, but unless the authorities actually implement a new policy to weaken ILS, the currency will likely stay strong.

Morgan Stanley Research