In the case of investments outside the eurozone, investors must decide whether to take on or hedge currency risk. In particular, regarding exposure to fixed income, currency fluctuations can significantly influence risk and return. However, hedging is not free: its cost largely reflects the interest rate differential between the US dollar and the euro (plus the currency spread). According to forward contracts, hedging exposure to the US dollar for five years costs 1.5% per annum. Therefore, in our summary tables, we present our projections of final returns in the conclusions for the three dimensions: expected local return, hedged and unhedged in euros.
In previous years, hedging exposure to the US dollar was the right decision, in line with our recommendation. This has not been the case over the past year, during which the EUR/USD exchange rate depreciated by 3%. Looking ahead, we continue to foresee a weakening of the US dollar over the next five years, but the expected losses (5.3%, based on a target of 1.20) would still be somewhat lower than the accumulated costs of hedging, which are around 7.7%. That said, this five-year benefit carries greater volatility (7.4% per annum, according to historical data).
As in previous updates, we developed our EUR/USD exchange rate forecast in three steps. First, we used two quantitative approaches:
(a) A mean reversion framework based on purchasing power parity (PPP)
(b) Projections based on a fair value model of the financial markets.
Second, we applied a qualitative adjustment to the average of these two approaches. Finally, we added the carry implied in the forward contracts (the opposite of the hedging costs) to obtain the expected benefit (+) or disadvantage (–) of unhedged exposure to the USD versus hedged.
For point (a), we used the latest OECD PPP values and estimated their future evolution based on the real and expected inflation rates for the US and the eurozone. This exercise forecasts that the PPP will rise from an estimated current value of 1.408 to 1.422 by 2031. Assuming a mean reversion of 13% per annum towards the PPP with a five-year average lifespan (reducing the difference by approximately 13% per annum), this implies a spot exchange rate of 1.276 in 2031.
For case (b), we used a model based on the 10-year yields of US bonds and the Bund, the risk differentials of the Economic and Monetary Union (EMU), risk sentiment (approximated by the S&P 500), and the price of oil as input variables. This model explains about two-thirds of the variation in EUR/USD since 2020 (previous central chart). The model indicates a slight undervaluation of the EUR/USD of 0.8%. We assume that three-quarters of this difference will close by 2031. Unlike previous years, model-based projections point to a EUR/USD exchange rate that is only slightly higher, at 1.15, mainly because we now expect the US interest rate differential to remain around its current high level of 170 basis points. The average of the two approaches yields a target of 1.213. The fundamental overvaluation of the US dollar suggested by purchasing power parity (PPP) is confirmed by the IMF analysis: this year's IMF External Sector Report points to a 20% overvaluation of the US dollar and a slight undervaluation of the euro of around 2.5%.
Our qualitative analysis takes into account several countervailing forces. The structural arguments against the US dollar remain strong. The dollar is fundamentally expensive, and the high US twin deficit requires continuous capital inflows. Increasingly, these come from equity capital inflows driven by artificial intelligence, while more reliable bond inflows have faded (right-side chart). Moreover, political uncertainty in the US, attacks on the independence of the Fed, and the recent flirtation of the Administration with financial repression may lead foreign investors to demand a discount on the currency and reserve managers to further diversify their portfolios away from the US dollar.
That said, several forces continue to support the dollar. First, the dollar greatly benefits from the economic strength of the US. US productivity growth is expected to outpace that of the eurozone for longer, and we also expect the federal funds rate to exceed the ECB deposit rate by a greater margin than we anticipated a year ago. Second, we also expect energy prices to remain high amid a prolonged conflict between the US and Iran, which will weigh on the euro due to the rising import bill (unlike the US, which is a net energy exporter). Third, higher global yields also make markets more prone to discount fiscal concerns through wider spreads on European government bonds (EGBs), which weighs on the euro. Finally, Europe continues to struggle to achieve greater integration in a context of losing international competitiveness and increasing global fragmentation.
In short, we believe that the factors favouring the US dollar slightly prevail, so we apply a moderate discount to the average of the two models and set our updated five-year forecast at 1.20. This implies an annual depreciation of the dollar of 1.1%, which is lower than the cost of hedging exposure to the dollar through forward contracts (1.5% per annum). However, given the historical volatility of the foreign exchange market of 7.4%, the resulting additional return of around 0.4% per annum is not attractive on a risk-adjusted basis. This implies an expected annual Sharpe ratio (SR) of only 0.06 for the open exposure to the US dollar (excess return relative to foreign exchange market volatility), a small fraction of the approximately 0.3 that we expect, for example, for investment-grade (IG) credit in euros. Therefore, hedging may still be the preferred option.
