Even Europe’s Draghi-Led Market Euphoria Can’t Buoy the Euro

Photographer: Roberto Monaldo/LaPresse/Bloomberg

European bonds gave Mario Draghi a seal of approval last week. The euro suggests he’s not quite the silver bullet for the region’s challenges.

As Italy’s debt markets were breaking records off the back of Draghi’s appointment as Premier-designate, the euro endured a second week of declines and fell below $1.20. It’s a sign that the currency bloc’s problems may be more ingrained than the fate of its third-largest economy.

“The only supportive elements for the euro at the moment are really the somewhat hawkish European Central Bank,” said James Athey, a money manager at Aberdeen Standard Investments. “The euro will likely head down to $1.17.”

A return to calm in Italian politics after a bout of turmoil usually tends to boost the euro. Not so this time, despite Draghi’s credentials as head of the ECB for nearly a decade and as the man largely credited with saving the currency bloc. It was certainly a boon for Italian bonds and some its periphery peers, as well its stock markets.

Yet currency investors are realizing the pandemic is exerting greater force over the euro. Europe has been left behind in the vaccine race by the U.S. and U.K., whose immunization programs are rocketing along. Hopes for a rapid recovery in these countries have steepened bond yields, resulting in flows into the dollar and the pound at the expense of Europe’s common currency.

Instead of positioning for the euro to appreciate, investors are scaling back longs, according to Societe Generale SA. Three-month risk reversals, an options gauge of positioning and sentiment, show that traders are the most bearish on euro-dollar since June last year. Versus the pound, it’s the most since March.

“Better U.S. versus European growth has been a catalyst for those positions to get squeezed out,” Kit Juckes, a strategist at Societe Generale, said in reference to euro longs. “And we can’t build a base for more euro strength without getting them down.”

Europe’s Challenges

Europe has administered just over three vaccine doses per 100 people, compared to over 16 in the U.K. and over 11 in the U.S. That’s of particular concern for Italy, where debt as a share of economic output has risen close to 160%, second to Greece as the highest in the euro area. One of Draghi’s priorities will be how to spend its package of grants and loans from the euro area to help turn that around.

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Europe’s challenges have been captured by its deeply negative real rates, which reflect the return investors receive once inflation is stripped out. Expectations for price increases in the region have climbed, yet yields have not kept pace, thanks to the weight of European Central Bank bond buying.

So while real yields in the U.S. have stayed broadly steady, Germany’s are plumbing record lows, resulting in the widest gap between the two since May. And it’s a dynamic that has dimmed investors’ optimism in the euro, according to Societe Generale.

Expect Weakness

Indeed, the euro has lost the momentum that took it to the highest level versus the dollar since 2018 last month. The region is facing a loss of economic output potentially to the tune of 100 billion euros ($120 billion), should it take longe rto close its vaccination lag. Deutsche Bank AG and Nomura International Plc are among banks recommending investors position for even more weakness.

But that hasn’t dented interest in opportunities in European bond markets. Mohammed Kazmi, portfolio manager and macro strategist at Union Bancaire Privée, sold German bund futures last week on the news that Draghi had been asked to form a government. There’s room for periphery bonds to attract flows from the core, Kazmi said.