One-day T-bill rivalry arises in European pandemic bonds

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(Bloomberg) – The European challenge of US dominance in global financial markets has just received a boost.

After a record-breaking first bond sale by the European Union this month to help fund its pandemic recovery, traders are wondering if the region’s assets could one day become an alternative safe haven to Treasuries. This was just the first salute in the bloc’s plans to sell nearly $ 1 trillion in debt in the coming years, a move that will forge a full-fledged market that could eventually attract investors to the euro in the future. dollar expense.

Of course, it is still quite a distance away. The US Treasury has over $ 20 trillion in debt outstanding over multiple maturities, a rich history of issuance, and none of the political dramas that have hampered the integrity of the EU in recent years. But with questions raging over whether US debt is losing its effectiveness as a hedge, global reserve managers have recouped nearly 40% of the EU’s recent 10-year social debt sale. , and investors and policymakers are starting to envision a greater role for the euro in global markets.

“Although the Treasury market is still much larger, this is a big step forward,” said Francesco Papadia, former director general of market operations at the European Central Bank and now a senior fellow at the Bruegel think tank at Brussels. “When thinking about the international use of the euro, there were two big related limitations: the absence of something like US Treasuries and also a safe yield curve for euro assets. These are partially addressed by this major EU bond issue. “

Since its inception over two decades ago, the euro has never posed a realistic threat to the dollar’s prominent position in the global financial system. Among the main obstacles are the benchmark status of the greenback in international trade, the institutional flaws in the EU exposed during the eurozone crisis and the lack of a safe haven denominated in euros.

The latter received a major boost this year after member countries overcame their differences for a groundbreaking joint budget plan to finance economic recovery from the coronavirus crisis. It’s a move that seemed implausible before the pandemic – the idea of ​​jointly issued debt was ruled out even during the perils of the eurozone crisis – and testifies to faith in the resilience of the European project after a troubled decade. .

Investors have also gained confidence. A measure of the likelihood of a country leaving the euro in the next 12 months is near an all-time high, based on a monthly survey of individuals and institutions. At the same time, the share of global reserves held in euros jumped 4% in the latest quarterly data, the most since early 2018, exceeding a gain of 1.9% in dollar equivalent.

However, European policymakers have shown little interest in promoting policies that could strengthen the international status of the euro until recently. The turning point was an address by former European Commission President Jean-Claude Juncker in 2018, according to Marek Dabrowski, co-founder of the Warsaw Center for Social and Economic Research.

“It was a response to the growing incidences of protectionism and unilateralism in the US administration under President Donald Trump,” said Dabrowski, who wrote for the European Parliament on the euro challenge against the dollar. . “Now, if you read ECB documents, they seem more favorable to the process of internationalization.

ECB President Christine Lagarde said in June that reform measures to tackle the virus should also serve to keep the euro attractive globally. This followed a call from European Commission President Ursula von der Leyen to “strengthen the international role of the euro” in her agenda for Europe when she took office last year.

Dollar pessimism

Markets could also support a longer term shift in favor of the euro. The currency has gained more than 4% this year to around $ 1.17, its second best performance since 2007. Debt sharing could help it climb further to a six-year high of $ 1.30 in 2021, according to Peter Chatwell of Mizuho International.

Many banks are now seeing the US currency entering a downtrend that could last for years. Key to this is the Federal Reserve’s decidedly accommodating policy bias, which erodes the greenback’s interest rate advantage and makes dollar assets less attractive. The additional yield on 10-year Treasuries over German bunds is 145 basis points, up from 210 at the end of 2019.

“The biggest exchange rate trend, now and for a long time, will be the downward convergence in interest rates induced by Covid,” said Kit Juckes, chief currency strategist at Societe Generale SA. “This, I think, is clearly negative for the dollar and far from being reflected.”

At the same time, the unprecedented fiscal stimulus unveiled by US policymakers threatens to worsen the US budget deficit – another negative point for the dollar. The deterioration of the country’s external accounts is also weighing on the currency.

Crédit Agricole SA strategists see the long-term fair value of the euro against the dollar at around $ 1.24. They expect downside risks to US growth, an accommodating Fed and concerns about the country’s fiscal health to drive diversification out of the greenback into the euro. New European bonds provide an ideal home for such rebalancing flows, they say.

“ Multipolar world ”

For now, the expected volume of EU bonds remains pale relative to the US Treasury bill market. The bloc plans 100 billion euros ($ 117 billion) in social bonds by next year and an additional 750 billion euros for its pandemic fund, of which about a third will come from green bonds. Its appetite for joint broadcasts will therefore have to survive the economic crisis induced by the coronavirus.

“These are targeted and temporary measures, they are not yet permanent,” said Alvise Lennkh, executive director of credit rating provider Scope Group. “If these measures were to become permanent through political decisions in the future – for example, the creation of a centralized fiscal capacity which would have a more permanent character – it would consolidate the claim of the euro.”

These problems, along with other advantages of the incumbent such as the use of the dollar to fix the price of oil, gold and other commodities, prevent analysts at Scope Group or Bruegel’s Papadia from see the euro push the dollar higher for the foreseeable future. But the events of this year are expected to lead to a narrowing of the gap between the shared currency and the greenback, they say, which in the decades to come could translate into a profoundly altered monetary universe.

“The global financial system is apparently moving towards a multipolar world with several dominant currencies rather than having a single hegemon,” said Valentin Marinov, head of the Group of 10 foreign exchange strategy at Credit Agricole, noting that the Chinese yuan will probably play a bigger role. to play. “I would expect central and eastern European central banks, for example, to further increase their holdings of euros and reduce their dollars.”

© 2020 Bloomberg LP

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