**EUR/USD Rally Overshoots Yield Spread Fair Value**
*Adapted and expanded from the original article by Kenny Fisher on Investing.com*
The EUR/USD currency pair has exhibited a surprisingly strong rally in recent weeks, gaining significant ground against the US dollar. While the euro’s advance appears to be influenced by fundamental shifts in market sentiment and economic indicators, analysis of yield spreads suggests that the current rally may have surpassed its fair value. A deeper dive into yield spreads, central bank expectations, and inflation forecasts helps clarify whether the euro’s appreciation is justified or if the bullish run is vulnerable to a correction.
Below is a comprehensive analysis of the EUR/USD rally, along with an evaluation of broader macroeconomic indicators, central bank policy outlooks, historical behavior of the currency pair during similar market conditions, and where the euro might be heading next.
Overview of the EUR/USD Rally
The EUR/USD pair has surged in recent trading sessions, surprising many analysts who had expected the euro to face downward pressure due to lingering economic challenges in the Eurozone. Notably, the following have contributed to the rally:
– Reduced expectations for aggressive interest rate hikes from the Federal Reserve
– Signs that the European Central Bank (ECB) may pause or slow its rate-cut trajectory
– Improving economic sentiment within the Eurozone
– Broad-based weakening of the US dollar
Despite these drivers, the strength of the euro may have outpaced macroeconomic fundamentals.
Yield Spreads and Their Importance
The yield spread between US and German government bonds has traditionally served as a strong leading indicator for moves in the EUR/USD exchange rate. Historically, a widening yield spread in favor of US Treasuries has supported USD strength, while a narrowing spread has tended to buoy the euro. Essentially, investors compare returns between US and German bonds to assess which currency may offer better relative returns. When German yields rise relative to US yields, or when US yields fall due to anticipated rate cuts, the euro tends to strengthen.
Here’s a quick overview of the current dynamics:
– The 2-year US-German yield spread has narrowed in recent weeks, driven primarily by changing expectations for the US interest rate trajectory.
– This narrowing yield spread provides some justification for euro strength, but not necessarily to the degree observed in the market.
Current Deviation from Fair Value
Analysts use various models to estimate the fair value of currency pairs, with interest rate spreads being a principal input. Based on historical regression models that relate the EUR/USD exchange rate to the 2-year yield spread between US and German bonds, the fair value of the EUR/USD pair appears to be significantly below its current market level.
Key findings regarding the fair value estimate include:
– Historical models suggest that the euro is trading above its fair value by approximately 200 to 250 pips.
– The actual EUR/USD level sits well above where it should be based on interest rate differentials alone.
– This divergence indicates a possible overreaction by markets or the influence of non-yield based factors such as speculative positioning or geopolitical sentiment.
Market Pricing of Central Bank Policy Paths
To better understand the yield spread dynamics, one must consider the policy outlooks for the Federal Reserve and the ECB.
Federal Reserve Outlook:
– The US Federal Reserve remains data-dependent but has recently signaled a willingness to hold interest rates higher for longer to maintain progress on inflation.
– Persistent strength in US employment data and sticky core inflation have reduced expectations for multiple rate cuts by the Fed in 2024.
– As of now, markets are pricing in only one or two potential rate cuts by the Fed by the end of 2024, substantially revised from earlier expectations of three or more.
ECB Policy Outlook:
– The European Central Bank has already begun a more dovish transition, with President Christine Lagarde offering cautious tone on growth.
– Economic weakness in Germany and France has pressured the ECB to take a more accommodative stance.
– Nonetheless, speculation of rate cuts has receded slightly, with the ECB expected to proceed with
Read more on EUR/USD trading.