EUR: Flows Following Fundamentals - Credit Agricole

Recent headlines that the ECB may buy corporate bonds and the upcoming stress test results (October 26) top investors list of things to watch in Europe. Indeed, both will have long-term implications for policy and thus relevant for EUR.

That said, this week saw the release of important balance of payments data that underscore our medium-term bearish outlook. We highlight two factors worth noting.

First, the moderation in one of the EUR’s key driver’s that helped the EUR rally 17% from mid-2012 to mid-2014 persists. Indeed, portfolio flows as percentage of GDP peaked early in 2014 and the outlook points to further downside risks for EUR over 2015. By the same token high frequency ETF data show increased outflows from European equities through Q3 2014. We also note that portfolio flows correlate the best with the real effective EUR relative to the other components in the balance of payments (foreign direct investment and current account balance).

A search for yield and the large risk premium in EUR-dominated helped to drive the surge in flows after Draghi’s “whatever it takes” speech. However, given the sharp contraction in EUR risk premium (10-year periphery spreads to Germany), the potential for lower real interest rates and stagnation concerns EUR-denominated assets lost their appeal. In time, we only expect these drivers to worsen.

Second, we note that the pickup in domestic outflows (from Eurozone to foreign countries) also suggest the scope for further deterioration in the EZ flow picture, beside the lack of demand from foreigners into EZ assets. The recent data showed capital outflows on the rise, which in our view correlates well with the potential for lower real rates as the ECB embarks on large scale easing.

*CA holds long EUR/USD from 1.2660 with a target at 1.31 and a stop of 1.2350

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