In Search of New Foreign Exchange Equilibriums

March 23, 2012

Whether the euro looks resilient or weak depends on what comparisons to historical levels are chosen.  Intuitively one expects this besieged money to be on the defensive.  The Euroland economy is experiencing a recession.  The debt crisis is at best in remission as attested by painfully high bond yield spreads with Germany.  The Greek problem for a variety of reasons could turn acute again before late summer.  The macroeconomic landscape is a negative.  Fiscal austerity will keep unemployment rising and GDP growth in a floundering state.  Monetary policy is more accommodative than Germans want, and inflation has exceeded the 1.9% target ceiling since November 2010.  It isn’t surprising that the trade-weighted euro has depreciated almost 10% since early May 2011 when Portugal became the second member of the currency union to file for an outside debt bailout.  Since peaking at $1.6038 on July 15, 2008, the euro has lost 17.4% against the U.S. currency and marginally over 35% against the yen.

From a different vantage, however, the euro appears sturdier and entrenched in a long-term zone of equilibrium.  The euro began life at $1.1720 and got off to a poor start under the first ECB President, Wim Duisenberg.  He held that post for the first 58 months of the euro’s existence, a period (end-1998 through end-October 2003) during which the euro recorded an average value of $0.9850, or 25.7% below its present level.  The all-time bottom of $0.8228 in late October 2000 was some 30% weaker than the starting point, but the euro actually had a weaker annual average level of $0.8952 in 2001 than its calendar 2000 mean of $0.9234.  The mean in 2002 was also below 95 U.S. cents, but the common currency began to find its legs in 2003 when it averaged $1.1321, still less than its birthing weight.

The euro has gone through only two broad stages, value-wise, since that transitional year of 2013.  The shorter of these was the first one, which was interrupted by the U.S. housing market crisis and ensuing global financial crisis.  Similar annual averages in the key EUR/USD relationship were posted of $1.2442 in 2004, $1.2439 in 2005, and $1.2569 in 2006.  The mean over those sequential years was $1.2483.  The financial crisis began in August 2007, intensified sharply after the collapse of Lehman in September 2009, and spawned Europe’s debt crisis just over a year after that when an incoming Greek government admitted that its deficits were far larger than reported earlier.  So Europe’s derived crisis has now stretched over about half the broader period since the global financial market crisis was sparked by a U.S. economic imbalance.  Late 2011 found the United States entering its third year of uninterrupted recovery but Europe drifting back into recession. 

In spite of the dichotomy in the U.S. and Euroland economies, the dollar’s average value of $1.3923 last year fits the pattern of the four prior years, when averages were posted of $1.3710 in 2007, $1.3942 in 2009, $1.4707 in 2008, and $1.3258 in 2010.  If one averages 2008 and 20010, the euro’s strongest and softest years in that span, the result of $1.3983 forms a very tight shot group with the other years and the five-year 2007-2011 mean of $1.3909. 

The question to ask now is whether the euro’s current level of $1.325 and year-to-date mean of $1.3087 in fact represent a departure from its 2007-2011 equilibrium.  The average of the 2004-06 mean of $1.2483 and the 2007-11 mean of $1.3909 is $1.3196, more or less where the market stands at present.  Thus, from the perspective of the euro’s whole history, the currency’s present situation constitutes a cup that is more than half full.  It’s above its starting level and above its lifetime average level, and — in spite of two enormous 3-year LTRO operations in December and February that greatly enlarged the ECB’s balance sheet — it is only marginally weaker than the $1.3345 mean over the eight years when Jean-Claude Trichet was president of the ECB.

From an even longer time perspective, one realizes that the euro packs less firepower than its ancestral European hegemon, the German mark.  In the 13-1/4 years of euro existence, the common currency has appreciated 13.1% against the dollar or 0.9% per annum.  Over the 30 previous years, the mark advanced 37.7% on balance or 2.5% per annum.  Even the mark, however, was no match for the yen, which rose 3.9% per annum against the dollar over the same 30 years.  The euro has also lost ground versus the yen, falling from a high of JPY 170 in July 2008 to JPY 109.2 at present.

The main reasons why the dollar hasn’t performed better in the long run are 1) the inherent burdens of being a dominant reserve currency with enormous offshore holdings and 2) considerable fundamental deterioration in the U.S. economy this century.  Among the latter are sub-trend growth in jobs and GDP, a continuing chronic current account deficit, extremely accommodative Fed policy with dollar depreciation being a main objective of that stance, and a dysfunctional political system that seems incapable of implementing short-term economic support but a long-term remedy to reduce the budget deficit and debt.  Highly imbalanced distribution of incomes are a further impediment but derivative of the above problems.

Other key currency relationships show some interesting patterns.  Commodity currencies had a great run from late 2008/early 2009 to last summer.  The Aussie dollar rose 64% to $1.108 last July 27, while the kiwi shot up 81% from $0.4896 on March 4, 2009 to a peak of $0.8840 on August 1, 2011.  The current levels, $1.039 and $0.812 remain above the post-July 2007 means of $0.9046 and $0.7234.  In Europe, the Swiss franc continues to shadow the euro by policy design, averaging 1.218 since last September 6 when the policy was announced by Swiss National Bank officials.  Sterling hit 52-week lows of 0.8222 per euro and $1.5233 in early January of this year but is now a bit above its post-2010 mean values.

Copyright 2012, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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