Comment on Euro-Yen Currency Pair

August 21, 2017

In spite of wide short-term variability in the euro’s yen cross rate, the relationship has been pretty stable over the long run. The financial crisis that began ten years ago this month occurred roughly 8-3/4 years after euro was created by merging several European currencies and putting all members of the newly formed euro area currency union under the jurisdiction of a single European Central Bank’s management. The average euro/yen exchange rate (EUR/JPY) since the start of the financial crisis has been 131.9, a 3.8% appreciation of the euro relative to the 127.1 average in this key currency pair over the period between the euro’s launch at the end of 1998 and the beginning of the financial crisis.

EUR/JPY has exhibited considerably more volatility since the financial crisis than the above comparison of period averages suggests. The Euro peaked against the yen at 170 on July 23, 2008 and touched it’s low of 94.075 almost exactly four years later on July 24, 2012. By the final week of 2013, the euro had rebounded to a tad more than 145 yen, but it had dropped back below 110 briefly in the final week of June 2016. The euro on average was stronger than its current 10-year mean during 2015 but weaker than such last year and this year, averaging 120.3 in 2016, 121.0 in the first quarter of 2017 and 122.4 in 2Q17. The euro’s yen value since the middle of this year, 129.6, has been very close to its 10-year mean.

Economic fundamentals facing Japan and the euro area are pretty similar, so it makes intuitive sense that the EUR/JPY has displayed a stable long-term equilibrium. Over the year through the second quarter (2Q17), real GDP expanded 2.2% in Euroland and 2.0% in Japan. Euroland’s current account is in a surplus that over recent years has averaged 3.4% of GDP, while Japan’s current account surplus/GDP ratio has also hovered slightly above 3.0%. Inflation is below target in both economies, more so in Japan where the risks of deflation are still simmering. But neither the European Central Bank nor the Bank of Japan has yet abandoned quantitative monetary stimulus and a negative marginal short-term interest rate. The BOJ maintains a target on its the ten-year Japanese sovereign debt yield of around zero. The ECB has no such target, but the 10-year German bund yield is very low at 0.40% nonetheless. Japan has a much bigger budget imbalance than the euro area as a whole. However, a lot of Japan’s fiscal deficit constitutes liabilities to its own citizens, and Euroland lacks a unified fiscal policy and has members with huge deficits.

Geopolitical risks are a fact of life for both Japan and the euro area. Japan is close to North Korea and thus must cope with the reality of an exceedingly short launch to target warning time should North Korea fire nuclear-armed missiles. Euroland has a trio of geopolitical menaces: Russian designs on its eastern front, domestic terrorism inspired by ISIS, and an unreliable NATO defense partner in the Trump administration.

Both the euro and yen lack key properties one would like to see in a reserve currency. Until the election of Donald Trump, markets had no reason to question America’s willing acceptance of the role of leader of the free world. With that responsibility explicitly no longer part of the U.S. government’s covenant with other western nations, it should not be assumed as was the case beforehand that the dollar would remain a hegemon among reserve currencies. But the dollar is not seemingly vulnerable as sterling became after the Second World War of losing its status as the most favored paper currency to another country’s money. No other national currency has all the necessary prerequisites.

This doesn’t mean the dollar retains its hegemony. It’s possible that the role of reserve currency may become more equally shared among a group of moneys including the dollar but also other currencies like the euro and yen. This possibility is not a clear and present danger and so not something that’s likely to bias EUR/JPY one way or another for now.

Copyright 2017, Larry Greenberg. All rights reserved. No secondary distribution without express permission.

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