Morgan Stanley’s Euro Optimism Bolstered by Key Rates Indicator

A closely-watched interest-rate metric has convinced Morgan Stanley strategists that the euro area can withstand further increases in borrowing costs, boosting their bullish view on the single currency.

(Bloomberg) — A closely-watched interest-rate metric has convinced Morgan Stanley strategists that the euro area can withstand further increases in borrowing costs, boosting their bullish view on the single currency.

The near-term forward spread — the difference between the three-month rate and where investors see it in 18 months’ time — is inverted for markets including the US and New Zealand, but remains roughly flat for the euro zone after declining in January. That’s a sign that the European Central Bank can keep cranking up interests to tamp down on inflation without having to worry too much about the economic impact, said David Adams, head of Group-of-10 FX strategy at the bank. 

“When it’s very, very inverted, it’s a signal that the central bank has potentially tightened enough,” Adams said. “It’s consistent with the idea those economies are entering recession. In Europe, it’s relatively flat — a signal that Europe can handle higher rates.”

The euro has fallen against the dollar and the pound since early February, while options markets indicate that further weakness for the currency may lie ahead. But the prospect that the ECB can keep hiking rates against the backdrop of a resilient economy points to longer-term upside, in the view of Morgan Stanley strategists. 

They recommended going long the euro versus the pound back in November and see the pair heading back above 0.93 this year, from around 0.8880 now. The US bank sees the UK’s reliance on foreign capital and the economic challenges facing the country as a drag on the pound.

“We’re more bearish on sterling, especially compared to the euro,” said Adams. “EUR/GBP moving higher is our top conviction trade.”

Less Skeptical

Assessing just how much tightening is required to bring inflation to heel has proved a major challenge for policy makers and investors alike, given the time it takes for the impact of higher rates to filter through. While the euro area’s headline inflation is easing, a core measure that strips out food and energy has yet to decline. 

The ECB — the last major developed market bank to start hiking — has lifted rates by some 300 basis points since July. New economic projections next month will help determine how much more tightening is needed, Mario Centeno, a member of its governing council, said this week.

Euro Zone Is Seen Dodging Recession as Energy Crunch Eases

For now, a mild winter has eased the region’s energy crisis and labor markets are holding up, underpinning the European Commission’s view that the bloc will narrowly avoid a contraction this year. Money markets are betting on a peak rate between 3.5% and 3.75% by September, the highest priced so far in this cycle.

According to Adams, it’s far from a certainty that the near-term forward spread in the euro area will invert as in the US, where it fell to minus 110 basis points last month. 

“Last year investors were skeptical of the ECB forecast that the euro area could avoid recession, given energy prices were expensive,” said Adams. “At this point, they’re coming round to the view that Europe can avoid recession, if not by much.”

–With assistance from James Hirai.

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