Peter Schaffrik: Welcome back to European Markets. My name is Peter Schaffrick, and today is the 30th of April 2025. Since we last recorded this, we've seen the introduction of tariffs, the increase of tariffs, the decrease of tariffs, the amendment of tariffs, and the pause of tariffs, and it all has caused a tremendous market volatility. It certainly has caused market movements that were quite unusual and it has also led to quite significant movements in the FX market. In order to make some sense of it, I'm joined today by Elsa Lignos, our Global Head of FX Strategy. Thank you for being with us, Elsa.
Before we go to the FX side, I would really like to highlight an unusual move, particularly in the bond market. Typically, treasury yields and European yields are very highly correlated, they typically move in the same direction at the same time. Not so lately, the two charts that you're seeing shows a measure of how divergent they have been lately. The left-hand chart shows the change in ten-year and thirty-year bond and treasury yields since Liberation Day, and as you can clearly see, bond yields have been going down while treasury yields have been going up. The right-hand chart shows a rolling correlation, a measure of co-movement, and as you can see, it has dropped dramatically lately and now sits at a multi-decade low. So clearly the two markets have started to trade much more as if they're living in their own world.
Well, what could be the reason for this? Well, one explanation could be that in the US, the tariffs are growth negative and inflationary, whereas in Europe, their growth dampening but might also be disinflationary, thereby allowing the ECB to reduce rates much more than the Fed for instance. And to some degree, I guess there's a grain of truth to that, and in fact the ECB has been very dovish at its last meeting, and we have, as a consequence, reduced our long-standing terminal rate call from two 2.25 to 1.75. However, as the next two charts also show, in relative terms, the market has still pushed Fed expectations down and the spread differential, the rate differential, has barely moved. So I'm not necessarily sure that this is the only explanation for this, so I think this is a great opportunity to bring Elsa in. So Elsa, let's maybe start off easy. Have we seen genuine Euro strength or has it been more broad-based dollar weakness that has led to the move?
Elsa Lignos: It's more of the latter than the former. There has been some genuine Euro strength, but a lot of that came very early in March on the back of the German fiscal announcement more recently. A lot of what we've been seeing as a broad-based US dollar move, very sharp at times, but also now somewhat more stabilized in the last few days.
Peter Schaffrik: And maybe as a follow-up, what do you think is underlying that and how is that related to the somewhat unusual bond market movements that I highlighted earlier?
Elsa Lignos: I think there are two real channels for dollar weakness or conversely Euro strength. There's a growth channel and there's a liquidation channel and they play out in different ways and play out with different correlations to other asset classes. If you look at the growth channel, that's really been about an end to us exceptionalism. We went into this year with markets very constructive on the US outlook, an expectation that the Trump administration was going to lead with tax cuts and deregulation. That's not what's happened, and as a result, investors have had to reprice the growth outlook for the US relative to the rest of the world. Now there is an open question going forward, and I think mixed views on whether the US is going to be most hurt by this, given that they've implemented tariffs on everybody else in the rest of the world or whether other countries are going to be more hurt, given that under classic economic theory it would be the surplus countries, the exporters that feel more of the pain.
And I think it's a broader discussion we can have, but the jury is out from the consensus perspective. If you turn to the liquidation channel though, there have been points over the past month where markets were really worried about that channel, and particularly that weak prior to Easter week where you saw, as you mentioned, bonds selling off, equity selling off, but the dollar also selling off alongside them. And that's really unusual for the US dollar, it's actually much more hallmark of emerging markets where you see yields going higher and the currency underperforming. It didn't last very long, but when it did happen, it was really prompting questions about the role of the dollar, the sustainability of the dollar's reserve status. And we've discussed this many times in the past and there's definitely a longer term trend away from the dollar.
If you look at global reserves, for example, the dollar share peaked in the early two thousands above 70%. As of the end of 2024, it was sitting up 58%. I do think over time that we are likely to see an acceleration in that reallocation away from the dollar just given what we've seen in terms of policy choices made by the Trump administration. But acceleration does not mean that we're going to go from 58 suddenly to 30 or 20 or anything like that. A lot of investors constantly make the point, there really is no major other alternative to absorb all of the money that's held in the US today. So I'd see this more as a story of reallocation and reducing the overweight position in the market in US assets rather than a wholesale liquidation of US dollars.
Peter Schaffrik: That's really interesting. And maybe one last question just concretely, where do we think Eurodollar in particular is going, but probably more broadly what the FX story is for the rest of the year?
Elsa Lignos: Unusually, I normally find it a lot easier to trade FX on a one-week-to-one-month horizon, and I always think it's a bit harder to call the twelve-to-eighteen-month horizon. I think unusually at the moment it's almost the reverse, because in the short term a lot will depend on the upcoming data we get out of the US. We've got payrolls coming up this Friday, that's going to be critical in that if we see weakness, it's likely to signal to a lot of people that the damage is really being done to the US economy. That's likely to accelerate some of that growth channel negative dollar effect that I was talking about earlier.
But if you don't see the weakness yet, we probably have to wait a little bit longer. We've seen the weakness in the sentiment data, it's not yet necessarily come through in the hard data. If you look out there over a twelve-to-eighteen-month horizon, then it becomes more a question of whether you think the Trump administration can really deliver on the deregulation and the tax cuts they have promised? And if not, and you think there still going to be some scarring and some real damage from the tariffs, and you set that against the fiscal stimulus coming out of Germany, which I think we all agree is a big deal, it's just the timing is uncertain, it's likely to come later into 2026 rather than early in 2025, over a twelve-to-eighteen-month horizon, you can have a bit more conviction that the gap in front-end yields will narrow between the US and the Euro area, and that in turn should lead to some material buying of Euro-dollar as people hedges back on their US investments.
Now, if you overlay on that, the liquidation channel, there's a possibility that policy choices of the Trump administration could accelerate that move. But equally, there's a lot of market positioning for that, and so it's not clear that you're going to get that quick spike higher. Maybe if I take a step back and think about the last time that we got a sustained rally in Euro-dollar, it was 20 20, 2021 when we got that move up to 123.50, and at the time we felt it was very much driven by the compression of front-end yields with the Fed cutting at the start of covid, the ECB already at zero, and that led to that wave of hedges being put on. Now we could see the same thing happen, but with the added kicker of some asset reallocation away from the US where there is a huge overweight position on the part of European investors, which in anything would accelerate that move. So all of this likely to play out over the next one to two years. The timing is always very much uncertain, dependent on how fast the US economy slows and how fast the yield differential can compress between the US and Europe, but the direction of travel, I think of a longer run horizon is increasingly clear.
Peter Schaffrik: I think that concludes today's edition. First of all, thank you, Elsa for joining us. Thank you everyone for watching, and I hope you're going to join us again next time.
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