Understanding the EURUSD Risk Premium
The Euro pairs just got a boost this week from the fiscal space as the EU plans to issue common debt in the form of long-term bonds to be repaid 38 years from now. The announcement comes after Germany and France signaled one week ago that they agree with debt sharing.
Although still early to get excited, as the plans must go through each national parliament, investors reacted by longing the Euro. Not all Euro pairs rose (e.g., EURAUD and EURCAD are still in medium-term bearish trends), but some did – EURJPY and EURUSD in particular.
The implied risk premium for the EURUSD exchange rate is extremely high compared with two years ago. In the case of this exchange rate, the risk premium refers to the part of the USD price of Euro unexplained by the two-year interest rate differential. If the fiscal decisions announced in the last two weeks are the step towards common fiscal policy, investors might see such a risk premium as too high. Favoring a higher exchange rate for the EURUSD.
EURUSD Did Not Participate to Any Risk-On Rally So Far This Year
It was difficult to bid for the Euro in the last few years. While the Fed in the United States hiked the federal funds rate above 2%, the ECB kept the key interest rate in negative territory.
With every Fed’s rate hike and the ECB decision to keep the rate steady, the interest rate differential kept widening, favoring a higher USD. So the EURUSD dropped from 1.25 to below 1.07 and faced the coronavirus pandemic already with negative interest rates and low inflation.
However the playing field has leveled somewaht. The Fed lowered the rates to zero and embarked on a massive easing program, far more aggressive than the one ran by the ECB. The interest rate differential, therefore, shrank, and the Fed’s easing outpaces the ECB stance.
Another important development for the Euro comes from the rise in the widespread support for the common currency. A central bank has a mandate to keep inflation at bay while spurring economic growth and fostering price stability. No part of such a mandate is possible without trust in the currency and support for it.
As it turns out, the widespread support for the Euro is on the rise since 2012, fueling the ECB and European Commission conviction that they are on the right track when it comes to the monetary, and now fiscal policy measures taken.
With a lower risk premium, the Euro and the EURUSD in particular, may find investors turning to the old continent again. This would bring a further wave of confidence as the spreads will tighten further, helping indebted European countries to borrow cheaper from international financial markets.