EUROs share of FX reserves to increase driving Euro higher

Thanks to a learned friend for pointing this out.

The below chart shows Euro holdings of central banks across the globe since 2004. The current reserves of all central banks is USD 10.9 trillion out of which USD 8.8 trillion is allocated to FX assets. Euro holding are at USD 1.7 trillion or 19.28% of allocated holdings. (Data source is IMF website).

·        The share of Euro increased from 2004 to 2010 as concerns on sub prime crisis and post crisis events, weakened the confidence in USD. This indicates that central banks shift and allocate assets as events unfold.

·        Since 2011 Eurozone crisis, the holding for Euro assets decreased and in percentage terms continued to decline till 31 Mar 2017 when EURUSD was at 1.0650.

·        It is noteworthy that European bond yields and equity markets now do not indicate to any risk of euro zone dismantling unlike the period of 2011 – 2015, as the political climate in euro zone has significantly improved post French and Netherland elections. Italian 10 Y yields hover at 2% while all other major EU government bonds are well below Italian 10 Y yields. Greek 10 y yields are at 5.6% now.

·        As the second half of the 2017 passes the tail risk of Italian political risks unfolding also has reduced. Markets would now watch German elections in September 2017 where Merkel is in the lead.

·        On the other hand the political climate in the US has deteriorated with economic and reform policies on the backburner.

·        It is likely that in the next 2 years we see the percentage of Euro holdings going towards mid 20s. A 5% increase in euro holding should result in additional Euro demand of USD 440 bn over the next 2 years. Euro zone current account surplus is Euro 350 billion and therefore even 100 billion USD of additional demand in one year, could be good enough for euro to go higher by 10%.

·        The inflation trajectory and movement in current account data, according to the above hypothesis should be irrelevant for Euro to go higher as most important is the political certainty that Euro provides from here on and central banks reallocate their assets.