How far will the Euro fall?

Financial Mirror (Cyprus) - - FRONT PAGE -

The US dollar is hit­ting new 12-year highs al­most daily, while the euro seems to be plung­ing in­ex­orably to be­low dollar par­ity. Cur­rency move­ments are of­ten de­scribed as the most un­pre­dictable of all fi­nan­cial vari­ables; but re­cent events in for­eignex­change mar­kets seem, for once, to have a fairly ob­vi­ous ex­pla­na­tion – one that al­most all econ­o­mists and pol­i­cy­mak­ers ac­cept and en­dorse.

French Pres­i­dent François Hol­lande, for one, has ec­stat­i­cally wel­comed the plung­ing euro: “It makes things nice and clear: one euro equals a dollar,” he told an au­di­ence of in­dus­tri­al­ists. But it is when things seem “nice and clear” that in­vestors should ques­tion con­ven­tional wis­dom. A strong dollar and a weak euro is cer­tainly the most popular bet of 2015. So is there a chance that the ex­change-rate trend may al­ready be over­shoot­ing?

In one sense, the con­ven­tional ex­pla­na­tion of the re­cent euro-dollar move­ment is surely right. The main driv­ing force clearly has been mon­e­tary di­ver­gence, with the Fed­eral Re­serve tight­en­ing pol­icy and the Euro­pean Cen­tral Bank main­tain­ing rock-bot­tom in­ter­est rates and launch­ing quan­ti­ta­tive eas­ing. But how much of this di­ver­gence is al­ready priced in? The an­swer de­pends on how many peo­ple ei­ther are un­aware of the in­ter­est-rate spread or do not be­lieve that it will widen very far.

Last year, many in­vestors ques­tioned the ECB’s abil­ity to launch a bond-buy­ing pro­gramme in the face of Ger­man op­po­si­tion, and many oth­ers doubted the Fed’s will­ing­ness to tighten mon­e­tary pol­icy, be­cause do­ing so could choke off the US eco­nomic re­cov­ery. That is why the euro was still worth al­most $1.40 a year ago – and why I and oth­ers ex­pected the euro to fall a long way against the dollar.

But the scope for dollar-bullish or eu­robear­ish sur­prises is much nar­rower to­day. Does any­one still be­lieve that the US econ­omy is on the brink of re­ces­sion? Or that the Bun­des­bank has the power to over­rule ECB Pres­i­dent Mario Draghi’s pol­icy de­ci­sions?

With so much of the mon­e­tary di­ver­gence now dis­counted, per­haps we should fo­cus more at­ten­tion on the other fac­tors that could in­flu­ence cur­rency move­ments in the months ahead.

On the side of a stronger dollar and weaker euro, there seem to be three pos­si­bil­i­ties. One is that the Fed could raise in­ter­est rates sub­stan­tially faster than ex­pected. An­other is that in­vestors and cor­po­rate trea­sur­ers could be­come in­creas­ingly con­fi­dent and ag­gres­sive in bor­row­ing eu­ros to con­vert into dol­lars and take ad­van­tage of higher US rates. Fi­nally, Asian and Mid­dle Eastern cen­tral banks or sovereign wealth funds could take ad­van­tage of the ECB’s bond-pur­chase pro­gram to sell in­creas­ing pro­por­tions of their Ger­man, French, or Ital­ian debt and rein­vest the pro­ceeds in higher-yield­ing US Trea­sury se­cu­ri­ties.

Th­ese are all plau­si­ble sce­nar­ios. But at least four fac­tors could push the dollar-euro ex­change rate the other way.

First, there is the ef­fect of the strong dollar it­self on the US econ­omy and its mon­e­tary pol­icy. If the dollar con­tin­ues to rise, US eco­nomic ac­tiv­ity and in­fla­tion will weaken. In that case, the Fed, in­stead of rais­ing in­ter­est rates faster than ex­pected, will prob­a­bly be­come more dovish.

Sec­ond, there must be se­ri­ous doubts about whether Asian and Mid­dle Eastern gov­ern­ments will in fact want to shift more re­serves into dol­lars, es­pe­cially if this means con­vert­ing the eu­ros they have ac­quired since 2003 at a loss and far be­low their pur­chas­ing power par­ity. Many coun­tries have spent decades di­ver­si­fy­ing their wealth away from dol­lars, for both fi­nan­cial and geopo­lit­i­cal rea­sons. With the US in­creas­ingly prone to us­ing its cur­rency as an in­stru­ment of diplo­macy, even of war­fare – a process known in Wash­ing­ton as “weapon­is­ing the dollar” – China, Rus­sia, and Saudi Ara­bia, for ex­am­ple, may well be re­luc­tant to shift even more of their wealth into US Trea­sury bonds.

A third fac­tor sug­gest­ing that the euro’s down­ward trend against the dollar may not last much longer is the trade im­bal­ance be­tween the US and Europe. The gap is al­ready wide – the In­ter­na­tional Mon­e­tary Fund fore­casts a $484 bln deficit this year for the US, ver­sus a $262 bln sur­plus for the eu­ro­zone – and is al­most cer­tain to widen much fur­ther, ow­ing to the euro’s 20% de­pre­ci­a­tion since the IMF re­leased its es­ti­mate last au­tumn.

The i mpli­ca­tion is that hun­dreds of bil­lions of dol­lars of cap­i­tal will have to flow an­nu­ally to the US from Europe just to main­tain the present euro-dollar ex­change rate. And as the transat­lantic trade im­bal­ance widens fur­ther, ever larger cap­i­tal flows will be needed to keep push­ing the euro down. Such huge cap­i­tal flows are en­tirely pos­si­ble, but what will drive them?

That ques­tion leads to the fi­nal and most im­por­tant rea­son for ex­pect­ing the euro’s decline to re­verse or at least sta­bilise. While higher US in­ter­est rates will at­tract some in­vestors, oth­ers will move away from the dollar if the com­bi­na­tion of a more com­pet­i­tive euro, the ECB’s enor­mous mon­e­tary stim­u­lus, and an eas­ing of fis­cal pres­sures in France, Italy, and Spain gen­er­ates a gen­uine eco­nomic re­cov­ery in Europe. The re­sult­ing flows of global cap­i­tal into Euro­pean shares, prop­erty, and di­rect in­vest­ment – all of which are now sub­stan­tially cheaper than cor­re­spond­ing US as­sets – could eas­ily out­weigh the cash and bond in­vest­ments at­tracted by ris­ing US in­ter­est rates.

What, then, can strike a bal­ance be­tween the op­pos­ing forces op­er­at­ing on the eurodol­lar ex­change rate? No one can say for sure, but one thing is cer­tain: Whereas the prof­its from play­ing transat­lantic in­ter­e­strate dif­fer­en­tials may run to 1% or 2% per year, in­vestors can eas­ily lose that amount in a sin­gle day – or even an hour – by buy­ing the wrong cur­rency when the trend turns. As we know from decades of Ja­panese and Swiss ex­pe­ri­ence, sell­ing a low-in­ter­est-rate cur­rency sim­ply to chase higher US yields is of­ten a costly mis­take.

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