The Euro is on a tear higher against the U.S. dollar. The EURUSD exchange rate, the one the European Central Bank (ECB) complains that is too high, hovers above 1.21 and trades with a bid tone.
Part of the strength is due to the U.S. policy. Another part is due to the European policy. Regardless of how you want to put it, one thing is sure – a huge divergence has built in the markets, and the FX dashboard usually sees higher volatility whenever this happens.
Three Reasons Why the Euro Is Overvalued Against the Dollar
Before starting, overvalued does not mean that the Euro is poised to depreciate against the dollar. In fact, just the opposite may happen, as the markets tend to remain in a divergent mode far more than traders remain solvent. Therefore, before trading a fundamental theory, make sure that the markets move first, and the trade comes second.
Coming back to the topic, it is obvious to everyone that the U.S. will outpace the European Union in the vaccine rollout. Unsurprisingly, the U.S. secured more vaccines in a timely manner, and the results start to show off. Therefore, there will be a lag between the economic performances of the two regions.
Second, the fiscal response in the United States outpaces the one in the Euro area. In fact, it dwarfs it. Third, the dollar already weakened last year, but the Euro strengthened. So far in 2021, we see the dollar’s weak trend continuing, as the GBPUSD or the AUDUSD pairs trade at the year’s high, but the Euro pairs are not at their highs. In fact, some Euro crosses are at their lows – EURGBP, EURAUD, EURCAD, to give some examples.
Implications of Higher Yields in the United States
The Fed signaled this week that it does not intend to taper the quantitative easing. However, it will be forced by the economy outperforming this year and by inflation surging. As such, when the Fed signals a tapering via forward guidance, the U.S. Treasury yields may be on their way to 3% or higher.
When yields are rising, the prices of bonds decline, as the Fed does not buy anymore. Moreover, if it decides to unwind the balance sheet to offload the bonds, the Fed may sell them, further putting pressure on the yields.
This may be a blessing for the ECB. According to some models run by various investment banks, a 3% rise in the U.S. yields by 2020 should trigger a more than 10% decline in the EURUSD exchange rate.
Often, positioning for such scenarios starts way earlier. As such, no one should be surprised by the markets reacting with anticipation.