EUR/USD is now over-valued (Morgan Stanley)
Friday, May 2, 2003
morganstanley.com
A further rally in the EUR against the USD and the JPY is definitely possible, with the former more likely than the latter. But such a move will have adverse consequences for the real economy of Euroland.
But such a move will have adverse consequences for the real economy of Euroland. We suspect that (1) the EUR/USD ascent will turn increasingly hesitant; (2) a strong EUR, coupled with a hawkish ECB, could be constructive for Bunds; and (3) since the EUR itself is over-valued, the EUR-peripherals such as the GBP, SEK, NOK, and CHF could out-perform the EUR at some stage of the USD correction.
What our valuation metrics say
We start with the results of our fair valuation calculations for the EUR. As we have been writing for some time now, we do not believe that there is only one distinct fair value or a fair value model for each currency. Rather, we believe that the relevant fair value of a currency might depend on the shifting emphasis that investors place on the underlying fundamental variables over time. All in all, 12 different specifications were used in our computations of the fair value of EUR/USD, EUR/JPY, and the EUR index. The median fair value of EUR/USD across these 12 specifications is 1.06, as of 2002Q4. At the current spot rate, EUR/USD appears to be over-valued in 10 of our 12 specifications. The outliers are the two models based on RID (real interest rate differentials). For those who have been following our research, these are the ‘bond culture’ models for EUR/USD. In trade-weighted terms, the EUR is also overvalued according to our valuation work, with the exception of the RID models. We observe that the median (out of the 12 models) overvaluation of the EUR Index is around 4.8%.
For EUR/JPY, the misalignment is even more stark. The median fair value for EUR/JPY is 116.7. A few models even suggest that the EUR/JPY fair value is below 100. The two outliers pointing to JPY over-valuation are models that are based on relative monetary growth rates, and these models appear to be both theoretically and statistically insignificant. (As we have discussed earlier, monetisation in Japan did not seem to result in JPY weakness. (See Money for Nothin’ and the Yen for Free, March 28, 2002.) We consider the PPP (Purchasing Power Parity) and the BEER (Behavioural Equilibrium) models to be more relevant than the monetary type models.
Different fair values for different perspectives
Essentially there are three broad perspectives on EUR/USD valuation: those that are centred on (1) the goods market, (2) bond-dominated capital market, and (3) equity-dominated capital market. PPP-based models can be considered to be focused on export competitiveness of countries, and, therefore, are focused on the goods market. Models centred on interest rate differentials describe an investment environment dominated by ‘bond culture’, while those centred on productivity differentials and GDP growth differentials better capture market dynamics dictated by ‘equity culture’. Thus, we conclude from our calculations that the EUR is over-valued from the goods market perspective. From the capital market perspective, the EUR is over-valued if we return to a market dominated by ‘equity culture,’ but is significantly under-valued if the ‘bond culture’ dominates.
Our thoughts
We have the following thoughts.
* Thought 1. The USD will continue to depreciate. As we argue in “Our Dollar Smile Returns,” the structural negatives of the USD remain intense. The ‘twin deficits’ of the US continue to grow, with the USD vulnerability index (the arithmetic sum of the fiscal and the trade deficits) having just broken through the important threshold of 7% of GDP and heading toward 9% of GDP by year-end. Indeed, according to the median of the 12 different valuation metrics, the trade-weighted USD Index is around 3.9% overvalued. While the current fair value of the USD Index may not be too far away from the current market spot rate, we expect the fair value itself to decline significantly over time. We have pointed out that the structural USD descent is roughly half-way complete, that over the coming 18 months, the USD index (measured by the Federal Reserve’s major USD index) may need to fall by another 10-15%. As the USD corrects, global capital flows may continue to be attracted into the most liquid alternative currency -- the EUR.
* Thought 2. The EUR/USD ascent is likely to be more hesitant than in 2002. A EUR/USD rally toward 1.15 will not be easy. We have pointed out that the first half of the structural USD correction has been rather ‘asymmetric’, in that it has come through mostly against the EUR and the European crosses rather than against the Asian axes (led by the JPY). This lopsided correction will have consequences for the symmetry of the USD adjustment in the period ahead. Specifically, this poses the risk that, as the USD resumes its structural correction and repels global capital into the EUR, the EUR could be pushed further into increasingly over-valued territory. Negative economic data will likely retard the ascent in EUR/USD, however.
One way we think about this issue is to consider the different perspectives of the capital market and the goods market. From a capital market perspective, USD assets will likely continue to look inferior to EUR assets, particularly from the perspective of global investors (e.g., Japanese investors). Further advances in EUR/USD could be justified from this capital account perspective. However, from the goods market perspective, a richer EUR would be inconsistent with the fundamentals in the real economy, and an over-valued EUR will eventually lead to negative economic consequences. From this perspective, EUR/USD reaching 1.20, as some investors speculate it could, seems rather unlikely.
* Thought 3. A hawkish ECB and an over-valued EUR should be positive for the Bunds. Recent comments from ECB officials suggest that they will not likely ease any time soon, against Morgan Stanley’s expectation of a cut of 25 bp in Q2. At the same time, however, an over-valued EUR will start to have adverse economic consequences for Euroland. This should be constructive for Bunds.
* Thought 4. The dominance of ‘bond culture’ matters for EUR/USD. EUR/USD may be over-valued according to most of our metrics, but it is still under-valued in our ‘bond-based’ models, i.e., the RID models. In other words the equilibrium value of EUR/USD, in an investment environment in which ‘bond culture’ dominates, could suggest another 6-7% of upside in EUR/USD. We’ve written on this topic before (Pondering the Re-Emergence of the Bond Culture, March 20, 2003). But the key point here is that, if bonds win this tug-of-war with equities, EUR/USD would have a much better chance of trading higher, because investors will likely trade EUR/USD by keying off of the same variables that drive the bond markets, which are more favourable for capital flows into Euroland than to the US.
Bottom Line
While it is, by now, widely (but not universally) accepted that the USD is over-valued and is due for a further correction, that the EUR itself is entering over-valued territory is not yet a consensus view. Our calculations suggest that the fair value of EUR/USD (the median of 12 specifications) is 1.06, and that of EUR/JPY is 117. This implies that EUR/USD is more than 5% over-valued, and EUR/JPY is more than 13% over-valued. The EUR-index is around 5% over-valued. In our view, a further appreciation in the EUR is likely, but it will have consequences for the real economy of Euroland. |
