Global: Euro Denial
Stephen Roach (New York)
The meltdown of the euro, in my view, qualifies as the biggest surprise so far in 2000. Yes, there have been other impactful
developments on the macro scene -- especially the about-face of the Nasdaq, a US inflation scare, a booming global
economy, and a supply-driven rally in Treasuries. But, to me, the trashing of the euro is the real stunner.
At the start of 2000, we all thought this would be the year of the euro. Even I, long the house euro-skeptic, had seen the
light. Our Euro team had finally beaten me into submission -- extolling the virtues of the region?s coming cyclical growth
surprise and the looming structural transformation that would finally improve Europe?s efficiency and competitiveness.
The story made sense, and it has turned out to be more right than wrong. Unfortunately, it made little difference to an
increasingly battered currency. I was also regaled with tales of dollar bearishness by some of the world?s greatest asset
allocators. Steeped in the lore of current-account-phobia, they argued that the dollar would fall like a stone under the
deadweight of America?s massive reliance on capital inflows. Asian managers of foreign exchange reserves were quite
explicit in stating their intentions to pare their dollar overweights and move into euros. This also made sense.
Unfortunately, it didn?t work either.
Then there was the New economy play in global asset markets. America personified all that was new and great about the
global economy. Its entrepreneurial, technology-led, venture-capital-driven model had won hands down. Nasdaq ruled the
world. And dollar-denominated assets were perceived to be the king of that same world. Until the air was let out of the
Nasdaq balloon, so the argument went, the dollar -- the "techiest" currency of the lot -- would reign supreme. Stephen Li
Jen, our currency economist, waxed eloquently on this point, and I must confess that this angle seemed particularly
appealing to me. It was the ultimate "relative price play" -- underscoring all that America had (especially its technology)
and all that Europe was lacking (also its technology). If anything could trigger a shift in capital flows that would have
currency consequences, this was it. Well the Nasdaq has now cracked. But the dollar is still standing as tall as ever. It?s the
euro that keeps on sinking.
A number of other things have happened along the way that have added to the euro?s woes. The April 15 G-7 communiqu‚
made no reference whatsoever to the euro -- an omission that was take in some quarters as tantamount to a repudiation of
currency targeting. Germany?s Ifo survey came in weaker than expected in March, raising yet another question mark over
the cyclical Euroland call. And the notorious Italian political wildcard came back into play, with yet another in a long string
of fallen governments.
Then there?s the woeful performance of the European Central Bank. Since its inception, the ECB has been in denial over
the fate of the euro. Initially, it argued that the euro?s launch value was a purely arbitrary benchmark that should not be
used to gauge any subsequent strength or weakness. It then modified its views to acknowledge that the euro could come
into play if it moved to the extremes that might impact inflation; with Euroland import prices now on the rise, that evidence
could well be at hand. Yet where is the ECB? Moreover, the ECB has a lot to learn in managing the rhetorical diversity that
plagues its 17-member board; it has spoken with multiple voices at key junctures for all too long. Both in public and in
private, Euroland central bankers are sounding more and more like US Treasury Secretary Michael Blumenthal in the late
1970s, whose policy of "benign neglect" led to the first of several dollar crises. Like it or not, the ECB has now fallen far
behind the credibility curve. And that hasn?t made it any easier for euro bulls.
Finally, there?s the Fed. By contrast with the ECB, the US central bank looks methodical and disciplined as it goes about
its task. To be sure, the Fed has been more incremental than I and others would have liked. But lacking a smoking gun on
inflation, Greenspan & Co. have opted for discretion over valor. And they are the masters of well-orchestrated spin. As the
Fed now tilts away from growth support to inflation targeting, it has left open the possibility of doing whatever it takes to
cap the upside of the price cycle. By contrast, there is no such upside to the ECB tightening cycle; euro-inflation risk pales
in comparison to that in the US, and currency targeting remains the stuff of backroom whispers rather than an explicit
policy objective. However, if the ECB were to come out of the closet and attempt to defend the euro in a climate of Fed
tightening, the possibility of competitive rate hikes between the two central banks could not be ruled out (see my April 24
dispatch, "Shifting Targets"). Working against a spread of 250 bps on official overnight lending rates -- a federal funds
rate of 6% and a euro refi rate of 3.5% -- the ECB faces a very steep uphill battle in this regard.
All this paints a picture of a seemingly chronic weakness in the euro. With the new European currency seemingly headed
through 90 cents on the US dollar, any residue of bullish sentiment is in tatters. It seems as if nothing could turn the story
around. And that?s, of course, precisely the way any asset feels at the bottom. Joachim Fels, our euro expert, remains
steadfast in his view that the euro has overshot to the downside and could well recover sharply in the second half of this
year. To be sure, his year-end 2000 call of 1.15 for the euro versus the dollar looks like more of a stretch than ever. But I
am very sympathetic to Joachim?s basic point that America is priced to perfection and Europe is priced for all that is
terrible. It is risks to those perceptions that will drive relative prices at the margin. I continue to believe that the US miracle
will face its sternest test at some point in 2000. During that test, euro comparisons could look a lot more favorable than
they do at present. We?ll know soon enough. |
