In 2011 the euro underperformed the US dollar by 3.2%. Given everything that’s occurred in Europe, many people have been surprised that the euro has not been weaker, and numerous commentators continue to call for a much weaker euro in this calendar year.
As usual with FX rates, most of the euro’s behaviour versus the US dollar can be explained by changes in expectations of short term interest rates, as seen by the relative differences between the regions’ short dated government bond yields. The euro’s strength against the US dollar in the first half of last year was due to the contrasting approach of the Fed and the ECB. The Fed continued to state that it would maintain an exceptionally low Fed Funds rate for an extended period (and then in August went a step further by stating that “economic conditions….are likely to warrant exceptionally low levels for the federal funds rate until at least through mid 2013”). Meanwhile, despite almost the whole market telling them it was daft, the ECB merrily hiked rates in April and July last year. Very predictably (see here), soon after the second hike, the markets promptly began to anticipate the ECB having to reverse its hikes (which it subsequently did in November and December) and the euro weakened over the remainder of the year.
The top chart shows the yield on German and US government bonds maturing in October 2013. The bottom chart shows the difference in the two yields plotted against the EUR/USD exchange rate, and the correlation is strong as you’d expect. However, the euro is now at a 15 month low versus the US dollar, and for this weakening trend to continue, we need one of three things to happen. Firstly, the Fed needs to do the unlikely, have a big change of heart, and hike rate rates before mid-2013. Secondly, which is quite possible, the normal correlation between EUR/USD and short term bond yields needs to completely break down. Or thirdly, German government bond yields need to get very negative.
Regarding the third point, Germany did indeed manage to issue 6 month bills at a negative yield for the first time (see here). If you eyeball the bottom chart, though, for EUR/USD to go to 1.15, you may need short dated German government bond yields to be as much as 90 basis points below short dated US government bond yields. Two year US government bonds currently yield +0.24%, so you’d be looking at German yields below -50 basis points. You’d end up with the interesting dynamic of investors going short of two year German government bond futures (the ‘Schatz’), not rolling the contract, and making free money (if they can ride out the volatility) at maturity.
Could German government bond yields get very negative? Well if investors increasingly doubt whether the euro can remain in existence, then negative German government bond yields are a totally rational outcome. Various analysts have had a stab at guessing where a new Deutschemark, Franc, Lira, Peseta or Drachma would trade versus the euro, and everyone seems to expect the new Deutschemark to strengthen against where the euro currently trades, although the range is huge with some going for 5% appreciation and some as much as 40% (for what it’s worth I’m actually not convinced a new Deutschemark would necessarily trade higher than where the euro currently trades given the damage that a euro breakup would do to Germany’s banking sector). It’s all obviously a total guess though as nobody has any idea, however it’s hard to argue against a new Deutschemark being a lot stronger than, say, a new French Franc and particularly a new Spanish Peseta, Italian Lira or Greek Drachma.
So increasingly negative German government bond yields, together with widening yield spreads between Germany and other countries, would be a rational response to the rising probability that the euro breaks up and the German government bond is redenominated into a new Deutschemark. Redenomination into a new Deutschemark could end up returning the holder of a -0.5% yielding short dated German government bond perhaps a 40% capital gain, or maybe even a 90% gain if the investor is living in Greece. Negative German government bond yields can very easily become more negative as the risk of breakup increases, leading to the problems discussed here. And the euro could therefore weaken a lot further.