DB FX Daily: Real Rate Differentials Favour Euro Even if Weak US Data is now Consensu

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FX Daily: Real Rate Differentials Favour Euro Even if Weak US Data is now Consensus

Real Rate Differentials Favour Euro Even if Weak US Data is now Consensus
The market consensus has shifted to generally expecting weaker US data and a weaker USD over the course of the past several weeks following a string of significant negative US data surprises and the break in EUR/USD above 1.3250-60 to an eventual high above 1.34. The building expectation for weaker data may be seen via our US macro pulse index (MPI) shown in the chart at left below which captures positive surprises on US activity data over the past month. The recent bounce in our MPI index shows more mixed data outturns as well as increasingly bearish expectations on many releases. As for the FX market, the run-up in the 25d EUR/USD risk reversal from 1M to 1Y tenors provides some indication of the sentiment shift in the FX options market on the back of the more bearish US cyclical news. Taken together with an observed increase in short USD positions, it may leave the FX market more open to isolated positive data surprises prompting some modest short squeezes in the USD such as seen with the release of existing home sales data last week.

While there may be a growing consensus around weak US data as well as the USD decline, it is worth noting that on the data front the US has yet to produce consistently positive data surprises since the very beginning of the calendar year even if expectations are now closer to the actual outturns. But the weaker activity data in the US has not been the sole driver of recent USD weakness. Persistent US inflation data and the rebound in crude oil prices has led to curve steepening in the US and an increase in US market derived inflation expectations - both of which we have found to be USD negative in the past. The dynamics of still weak US activity data, rising inflation expectations and steady European data may be summarized in the chart at right below which tracks the 10Y real US-Eurozone real rate differential from inflation indexed bonds against EUR/USD. Here one can see that real spread compression has been relentless. Therefore a few positive surprises on US activity data may not be sufficient to turn the USD trend. Such positive surprises may need to be followed by softer inflation data and lower crude oil prices to bring about a more sustained rebound in the USD.