EUR/USD: Excellent insight from Morgan Stanley

In 4Q14 and 1Q15, North American
funds bought EUR-denominated shares on an FX-hedged basis, but with the equity
market now declining, necessary portfolio realignments now require these funds to
buy EUR as the capital base of their EUR-denominated portfolio falls. This effect
receives additional support from weak risk appetite, reducing the incentive for
domestic investors to place funds outside the eurozone. Consequently, capital
outflows decline, falling below commercial EUR buying needs due to EMU’s current
account surplus of 2.2% of GDP. Italian bond yields reaching levels of US bond
yields and Spanish bonds now returning 6bp more than Italian bonds should reduce
EMU’s capital outflows too. For EUR to resume its downtrend, equity markets and
risk appetite will have to stabilise and yield differentials have to widen again in favour
of USD.

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