USD/EUR spread compression trade seems to be alive and kicking – Nordea

Andreas Steno Larsen, analyst at Nordea Markets, suggests that markets have so far also chosen to price in more cuts from the Fed than the ECB, even though the Euro-area outlook is probably worse than the US outlook, both on the growth and the inflation front and is simply a result of differing starting points.

Key Quotes

“The Fed simply has room to cut (materially), while it is much more exhausting for the ECB to convince the public of the need for more cuts even deeper into negative territory (with that said, we expect them to cut rates). The USD/EUR spread compression trade could continue to work based on this relatively simple line of thought.”

“Furthermore, we have noted how the Fed rarely (if at all) underdelivers versus market expectations of cuts. It can be too expensive not to deliver the expected cuts as the Fed risks to tighten financial conditions abruptly in that case. From a risk/reward perspective it continues to make sense to bet on the Fed delivering (at least) what is priced in.”

“Hence, USD hedge costs have likely already peaked last year as the Fed can “outcut” the ECB over the coming quarters, which will continue to compress short-end USD/EUR spreads as a consequence.”

“But this is not a green light for USD depreciation pressure as the rate spread is not a particularly good predictor of EUR/USD spot moves. We have a target of 1.08 for EUR/USD at the end of the year due to continued trade and growth tensions.”