| | Currencies: Seven Reasons to Sell the Euro
Joachim Fels (London)
May 18, 2005
Toss a coin…
As Alan Greenspan once famously remarked, forecasting exchange rates is like flipping a coin. This view has been supported by a vast amount of empirical literature ever Richard Meese and Kenneth Rogoff demonstrated in 1983 that a simple random walk model performed as well as any fundamental model in forecasting exchange rates at one- to twelve-month horizons (see “Empirical Exchange Rate Models of the Seventies: Are Any Fit to Survive?” Journal of International Economics, 1983, pp. 3-24). Having watched currency markets closely since around the time when the Meese and Rogoff paper appeared, and having even wasted three years of my professional career (from 1999 to 2002) flipping the exchange rate coin again and again, I fully subscribe to the view that currency markets lead a life of their own, more often than not divorced from economic fundamentals. Exchange rates tend to move around a lot in the absence of any discernible fundamental ‘news’ — commonly referred to as ‘excess volatility’. Conversely, exchange rates often fail to respond, or even respond perversely, to what is traditionally considered important ‘news’. In short, foreign exchange markets have an amazing ability to prove most people wrong most of the time. This is what makes them the most fascinating and humbling of all markets to me.
… and then look for a scapegoat
Still, as I see it, fundamentals do play an important role in foreign exchange markets, though in a very peculiar way. Put simply, while fundamentals are not at the root of most exchange rate movements, they frequently serve as a scapegoat. Market participants and observes use fundamentals to justify ex post exchange rate moves that have occurred for whatever unobservable reason (see also P. Bacchetta and E. van Wincoop, “A Scapegoat Model of Exchange Rate Fluctuations” NBER Working Paper No. 10245, January 2004). This is particularly true once a trend gets established in a currency pair. In my view, such trends are largely driven by momentum traders who trade on technical signals rather than fundamentals. As the Bank of International Settlements’ latest tri-annual survey of foreign exchange markets suggests, the importance of such technical model-driven players as opposed to fundamental players has increased over time. However, as soon as a trend develops, the pundits who earn a living by commenting on the markets start to look for fundamental developments that might justify the observed trend. After all, where there is smoke, there must be a fire.
The US current account deficit is a scapegoat
To illustrate the scapegoat model, just think back to the decline in the dollar against the euro over the last several years. Once the dollar had started its downtrend, the markets discovered the large and widening US current account deficit as the ‘reason’ for a weakening dollar. And so the pundits and the momentum traders joined forces to push the dollar ever lower. Note that the current account gap had been huge by traditional standards for a long time already. Yet, this was ignored by markets as long as the dollar remained strong. The markets’ favored explanation for the dollar strength at the time was the US economy’s superior growth performance. But when the dollar finally weakened (even though the supposedly important growth differential persisted!) the already existing US current account deficit became the scapegoat and has remained the battle cry of the many dollar bears ever since.
But markets need to look for a new scapegoat
Recent developments in the currency markets lend further support to the thesis that the current account deficit has been merely a scapegoat. Even though the US current account is now headed for a record $ 700 billion or so shortfall this year, the dollar has recently risen to a seven-month high against the euro, with EUR/USD breaking below the supposedly important technical barrier of 1.2730 last Thursday. Thus, after several months in which the dollar has gone nowhere against the euro, markets appear to have lost interest in the current account story. Why the dollar has failed to rally further this year I don’t know, but I suspect it has more to do with the ECB’s open threat earlier this year that it would not tolerate further euro strength than with any fundamental developments.
The euro bear trend has started (says my coin toss)
Moreover, with the recent dollar breakout, I suspect that we are now witnessing the beginning of a bearish trend for the euro. Thus, I fully share our currency team’s long-held view that the dollar will strengthen against the euro (for the team’s most recent exposition of the dollar bull case, see Stephen L. Jen, “G4 Currencies: The Dollar is Good, EUR/Asia to Trade Lower” FX Pulse 12 May 2005). As with the dollar bear market of the past three years, I think the coming euro bear market will take on a life of its own, with momentum players and bearish fundamental stories about the euro reinforcing each other. If so, the euro could fall a lot faster and a lot more than to the USD 1.20 level that our currency team foresees by the end of 2006. To put a number on my view, I think parity for EUR/USD could be broken within the next 18 months (but keep in mind Alan Greenspan’s view on what to think of such forecasts!). As far as I’m concerned, there is a plethora of potentially bearish stories about the euro around that are likely to gain currency in the coming weeks and months. Here’s my laundry list of seven reasons, or seven scapegoats, why the euro should and will fall against the dollar.
1) The euro is expensive
True, valuation is not a good guide to market direction, certainly not in the near term and often not even over the medium term. But when confusion reigns in currency markets, as now seems to be the case, participants often dust off their valuation models for guidance. Most standard valuation models suggest that the euro is overvalued relative to the dollar. Our currency team routinely runs twelve different valuation models, and the median fair value for the euro produced by these models is currently at US $ 1.13. Models based on purchasing power parity, including The Economist magazine’s Big Mac index, suggest a fair value closer to parity.
2) European growth continues to underperform
Trend GDP growth has been about twice as high in the US than in the euro area over the past several years, thanks to higher population growth and stronger productivity growth. Moreover, actual GDP growth in the US has exceeded its trend rate in recent years, while euro area GDP growth has fallen short of its (lower) trend rate. And the very recent indicators point to a re-acceleration of the US economy going into the second quarter, while the euro area economy is likely to have fallen back into near-stagnation this spring. Naturally, given my stagflation call for the US economy, I’m not optimistic on the medium term outlook for the US economy. However, the euro area, which has been very reliant on external demand, is likely to do even worse than the US in such an environment. True, labour markets have been made more flexible in recent years and there has been a moderate pick-up in productivity growth on the old continent. However, the recent wave of protectionism and anti-capitalist rhetoric in Germany and France does not bode well for further structural reforms anytime soon.
3) Interest rate differentials should benefit the dollar
US short-term interest rates are now one percentage point higher than euro area short rates. With the Fed still in (measured) motion and the ECB paralyzed at a 2% refi rate, the differential likely to widen further in favour of the US dollar. Further out the yield curve, ten-year US Treasury bonds currently yield 85 basis points more than ten-year Bunds, up from a negative yield gap a little more than a year ago. As I have argued before, US bonds look attractive at these levels relative to euro area bonds (see Buy Treasuries, Sell Bunds, Wear Diamonds, 28 April 2005). An unwinding of the currently popular long Europe versus short US bond trade should benefit the dollar.
4) The ECB’s credibility is eroding
The longer the ECB keeps rates unchanged at rock-bottom levels, the more likely markets will start to question its credibility. As I see it, there is a growing discrepancy between ECB rhetoric and action on three fronts. First, the ECB keeps worrying publicly (rightly so, in my view) about excessive money and credit growth and the related risks to financial stability, but has refrained from tightening policy because the real economy has been weak. Second, the ECB keeps emphasizing (again rightly so, in my view) the importance of anchoring long-term inflation expectations, but has stood by watching breakeven inflation rates hovering above its 2% ceiling without acting. Third, while the ECB keeps talking about the importance of fiscal stability (again, rightly so), it indirectly subsidizes the high-debt member states by treating all governments as equal in its weekly refinancing operations and thus preventing the market from punishing the fiscal sinners via higher sovereign credit spreads (see my article “Markets Can Punish Europe’s Fiscal Sinners” Financial Times 1 April 2005).
5) Fiscal deficits on the rise in Europe, declining in the US
While the US fiscal deficit appears to have peaked and is likely to decline this year, deficits in several large euro area countries, most notably Italy and Germany, are on the rise. The stability and growth pact is no longer a binding constraint since governments watered it down substantially in March, markets cannot fulfill their surveillance function due to the ECB ‘refi put’ (see above), weak economic growth is eroding the tax base, and the looming 2006 national elections in Italy and Germany will likely lead to further fiscal relaxation.
6) Europe is heading into a political crisis
Markets are still too complacent, in my view, about the increasing political fractures in Europe, which could ultimately even lead to a break-up of the euro (see my Euro at Risk 18 April 2005). Protectionism and anti-capitalist sentiment is on the rise in some member states, most notably Germany and France. Moreover, at least one country (e.g. France, the Netherlands, Denmark, Poland, Czech Republic, or the UK) may reject the EU constitution, which would imply policy paralysis in Brussels and more open disagreement on the EU’s future path. And the scope for more divergent fiscal policies in the member states of the euro bears important potential for conflicts, too. Markets will have to come to grips with the insight that, contrary to the founding fathers’ expectations, the single currency will not eventually be backed by a single government or a political union. This is why the euro will have to trade at a discount to the dollar and why it is unlikely to ever replace the greenback as the world’s reserve currency.
7) A rise in global risk aversion will favor the dollar
Following the recent corporate credit downgrades and the related events in structured credit markets, I expect investors to continue to reduce their exposure to risky assets globally, including emerging market exposures. As leveraged trades have traditionally been mostly funded in dollars, global risk reduction should push the dollar higher. As global trade slows, the dollar will be increasingly seen as a safe haven, supported by relatively (compared to the yen or the euro) high interest rates.
Bottom line
I emphasize again that I see currency markets largely driven by technical factors and momentum players. Economic fundamentals typically merely serve as scapegoats to justify ex post exchange rate movements that have occurred for unobservable reasons. The downtrend in EUR/USD since the start of the year suggests that the US current account deficit is no longer a good scapegoat to explain what has happened. The market needs a new scapegoat. In my view, one or several of the seven bear cases for the euro that I listed above will serve as such and will push the euro significantly lower in the remainder of this year. Coin flippers should use Eagle dollars rather than euro cents for now.
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