The US dollar popped weaker on most crosses late Tuesday. This stemmed from off-the-cuff comments from President Trump along the lines that he’s okay with some dollar softness, as it means that other currencies are less likely to devalue versus the dollar, in turn preventing their products from becoming more competitively priced in the US. This harps back to the so-called Mar-a-Largo accord that voiced frustration that dollar reserve status, while positive, resulted in a dollar that was too strong, in turn making US manufacturing less competitive. Our views on that are here (Q&A) and here (podcast).
Remember, it’s the US Treasury that has responsibility for the US dollar, not the Federal Reserve. Scott Bessent, on CNBC this morning, cited the “strong dollar policy” phrase. So, he has decided not to push in the same direction as President Trump. Indeed, the dollar does not need a push. It’s already moving along the path of least resistance – weaker. It’s the unwritten preference of the administration, but not too weak too fast, and not getting to uncomfortable levels. Our FX strategists have also maintained a weaker dollar view – it’s here.
So what does all this mean for the rates versus FX arbitrage? In recent weeks, we’ve opined on this for Japan and South Korea (here) and China (here). Now we focus on the eurozone, or more specifically, Ester verus SOFR.
The FX exposure piece – anticipating a weaker dollar
A weakening in the US dollar versus the euro should not be a huge surprise. It’s discounted in the FX forward profile, which is a reflection of the rate differentials between higher US rates and lower eurozone rates. If those spreads represent an equilibrium, then the EUR must appreciate versus the USD. That said, forwards are not always realised. A great example of that is the recent weakness of the Japanese yen. There, the forwards have not been realised as the rate spreads have not represented an equilibrium. Hence, the rapid tightening in spreads, mostly from higher Japanese market rates.
The big question from an Ester versus SOFR perspective is how the EUR/USD FX rate actually evolves versus the forwards. Our FX strategists have generally viewed the 1.20 to 1.25 range as a path we can absolutely venture along. Beyond that, it gets more hazy. Anything that threatened 1.30 would look a tad outlandish. So conservatively, we have 1.25 as a critical level, acting as something of a floor. As we glean along the FX forward profile (chart below), we hit 1.24 on the 3yr tenor and we’re at 1.26 on a 4yr tenor. That’s the area of inflexion from a rates tenor perspective.
The spreads piece – steady to tighter anticipated
The bias from the previous section is to avoid being short the euro versus the dollar on tenors out to 3.5yrs, as there is a material risk that the actual EUR/USD FX rate dips below the FX forward profile. If that happens, and we’re long carry (receive SOFR and pay Ester), the value of that carry is wiped out (as we have created a EUR liability that gets hurt on EUR strength). In that case, it’s best to be short carry (receive Ester and pay SOFR). That carry cost ranges from -c.160bp in the 1yr out to -c.140bp in the 3yr (see charts below).
For longer tenors, the implied breakeven for long carry plays is above 1.25 (as gleaned from the FX forward profile above). The area of real comfort is in the 7yr tenor, which has an FX forward rate of 1.31 (and the 10yr is even more comfortable at 1.36). The simple prognosis here is long carry is comfortable in longer tenors, provided there is a reasonable degree of comfort that EUR/USD does not venture above 1.25, with the 1.3 area as the ultimate pain point.
The basis piece is not a factor, but the FX entry point actually is
The EUR/USD cross currency basis, which is effectively an arbitrage between actual spreads and FX forwards, is practically zero at the moment. It used to reflect a sizeable dollar premium, which resulted in wider spreads than advertised (often, typically by some 30bp). That has disappeared, and is liable to remain absent. That’s good for the negative carry play, as it means no amplification of spreads. While for positive carry plays, it means that a prior positive arbitrage has gone, but at least has not flipped to a space where it actually hurts.
One clear plus for the positive carry play is the FX entry point has improved. Get in at as strong an EUR/USD rate as possible, and the risk for subsequent EUR/USD strength is reduced. Also, the FX forward profile shifts higher too, marking out a better breakeven prognosis. With respect to absolute spreads, the table below shows that absolute spreads are a tad lower versus their historical averages (by some 10bp). Still good entry points on absolute spreads ranging from 125bp to 150bp. And we expect these spreads to be biased tighter, towards the 100–125bp area, mostly from the Ester side. But not much in it.
Source: ING
