USD Weakness or EUR Strength? (Merrill Lynch)
(Morgan Stanley indicates that the EUR is overvalued pointing to 1.06 as real value. Go figure)
Wednesday, May 7, 2003
ml.comthe recent, sharp movement in currency markets has caught many investors by surprise. After all, the war is over and the US economic data are showing some signs of improvement.
At worst, one might have expected the US dollar to remain in a range versus other major currencies. Instead, the currency has come under renewed downward pressure while there has also been broad strength in the euro.
This is not a story of the growth cycle. While broad dollar weakness remains the most notable theme in foreign exchange, it is also important to appreciate the breadth of euro gains. Instead, it is a story of valuation adjustment, one of the final hangovers from the champagne enjoyed during the bubble economy. And there is a lot more to come.
Our valuation model, the FX COMPASS, puts fair value in EUR-USD at 1.31. We are forecasting a rise in EUR-USD to 1.15 by year-end and to 1.25 to the end of 2004. That said, even we are surprised by the speed of the move; the euro has risen above our June target. We believe there are three recent themes important to highlight.
1. Higher yielding currencies, parallel to credit
The latest downturn in the dollar has been led by emergingmarket currencies, which are responsible for more than 45% of the Federal Reserve’s broad dollar index. Effectively, investors are reaching the conclusion that the risk premium being offered in lower-rated credit and higher-yielding currency regions is a risk worth taking. The primary threat that could upset this trend is a renewed global recession. While a long period of low growth seems assured, the likelihood of a retrenchment in the US consumer is low in the context of the rebound in confidence.
Fixed income investors are well aware of the ‘search-foryield’ theme in the context of the sharp tightening in credit spreads. There is a direct parallel to currency markets. Just as US corporations are focused on financial consolidation so too are the governments in many emerging markets, which have been subject to strain in the past 2-3 years. The sharp narrowing in credit spreads has accompanied a rally in higher-yielding currencies, with the Brazilian real and South African rand leading the charge.
2. USD the worst of the funding currencies
The US dollar, Swiss franc, and Japanese yen, where money-market yields are exceptionally low, are all subject to downside risk through the phase of rising risk tolerance and search for yield. A second-order question, investors First, the US is a user of global capital whereas Switzerland and Japan are providers.
Foreigners are less likely to be willing to fund US foreign capital needs at very low yields than domestic investors, given the tendency for a bias toward home capital. Second, the strong performance of emerging markets is also a bigger hurdle for the US dollar. Again, counter to the experience of Switzerland and Japan, emerging markets compete with the US for the worlds’ savings.
3. EUR balance of payments entering virtuous cycle
Although dollar weakness may be dominating FX, one cannot help but be impressed by the strong performance of the euro. The currency is trading at multi-year highs versus the yen, Norwegian krone, British pound and Swiss franc. Clearly, the search for yield has not been the only theme in currency markets, with the euro offering much lower yields than the krone and pound. However, there is a reasonable explanation: the Eurozone balance of payments is turning to a virtuous cycle.
The fact that the region is running a current account surplus is old news. Through February the current account stood at EUR3.2bn, down slightly from a year ago but still a definite surplus. More telling are patterns in the capital account.
Whereas direct investment and portfolio flows were decisively against the euro a year ago, they are turning more favorable. The surplus in these categories of the capital account improved to EUR10.0bn in the twelve months to February versus an outflow of EUR2.75bn a year ago (see chart). Why the improved appetite for securities in the Eurozone? Well, partly from expectations that the strength of the euro will extend. Hence, the virtuous cycle. |
