Euro prospects on the rise

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Before the French elections in April, people were worried about a potential breakup of the euro. But just a few months later, the single currency has been gaining in strength significantly. So why is that? Well, to help answer that question, I'm joined today by Roger Hallam, who's Currency Chief Investment Officer at JPMorgan Asset Management. Thanks for joining us, Roger.

Good morning.

So first question, what's been going on with the euro?

I mean, the euro's rallied strongly so far this year against the dollar. I think there's been two things driving that. The European economy has continued to make progress with strong growth rates. We've seen an improvement in politics in the region.

At the same time, the Trump administration has faced a number of challenges. Has been unable to push through its reforms from either the health care or the tax side of things. And of late, we've also seen some very soft inflation prints out of the US, which has driven down expectations of Fed tightening, both this year and next.

Right. So we've got a stronger euro against the dollar. Is the euro still a good value for investors, do you think? We've got a chart here on this.

I think that depends on your time horizon. Certainly, it's rallied a lot in the last couple of weeks and we're seeing a little bit of position congestion over the last few days. But I think when you look at these charts, when you look at the euro from a long-term perspective. Here, we've expressed the euro on a real effective exchange rate basis. You can see it's still relative to its long-term averages, certainly isn't overvalued.

And what's the empirical evidence of that is the eurozone still operates at a very large and persistent current account surplus. It's come off a little in recent months as Europe has started to outgrow the rest of the world, but it's still symptomatic of an undervalued currency.

OK. And of course, we can't discuss the euro without discussing European Central Bank. There are people in the market who think that's a force that could drive the euro higher. What's your take on that?

I think that's fair. I mean, the ECB is certainly progressing towards announcing a tapering of its asset purchase, most likely at the October meeting, but the market is starting to look forward to that event.

Now certainly in the pre-crisis era, you can see that relative rate spreads-- and here, we expressed them as a eurozone less the US-- have been a predominant driver of eurodollar. But there were periods in-- obviously, the pre-financial crisis period here, where eurodollar diverged significantly from relative rate spreads. And that was certainly in the inception of the euro surrounding concerns about the viability of the euro project.

And then more laterally as we went through the decade, as reserves continued to build, largely in Asia. And they start to diversify those reserves out of dollar into euro as the euro sort of became accepted as a reserve currency, we saw some divergence between relative rates spreads and the direction of eurodollar.

And just on that point, on reserve flows, do you have any sense of where future flows might come from or the kind of trajectory on that?

Yes. And if you look at the end of this chart here, you see we're starting to see some divergence of eurodollar versus rate spreads. And if you go to the next chart, what we've seen in the post-financial crisis period was euro allocations--

These are central bank reserves?

Yes. This if from the IMF COFER data. The euro allocation in allocated reserves was something close to 28%. And in the post-financial crisis period and in the European debt crisis, this fell steadily over the last 5 to 6 years and reached a low of just above 19%. With the acceptance of greater stability in the eurozone from both a political standpoint and a growth standpoint, we think we will start to see reserve managers-- and also, I think private investors more generally reversing that under-allocation to the eurozone of recent years. And we expect this to move back up towards the mid 25% [INAUDIBLE]. And that's an extremely large capital allocation that needs to come back into the euro.

Also, we may well see private sector investors reducing their hedge ratios, which have typically been quite high in recent years on eurozone assets.

And I guess being encouraged by potential central bank flows themselves?

Indeed, yeah.

Roger, thanks for your time.

No problem.