When Might We See $1.20 Per Euro Again?
August 25, 2008
This question was put to me over the weekend. While the euro has not traded as low as $1.20 in 29 months, it is not an unreasonable query. $1.20 lies near this relationship’s long-term center of gravity. The euro opened at about $1.18 on its first day of trading at the start of 1999 and has a mean value of $1.148 over its entire life-span of almost nine years. Similarly, the Deutschemark’s average value during the last 11 years before the formation of the euro translates to $1.174 per euro. Currency trends have a tendency to overshoot, and the flip side of that property is a long-term tendency of markets to return to equilibrium after overshooting.
The questioner did not have a very long lapse of time in mind, however. The dollar had corrected 11.6% upward very quickly from $1.6038 in mid-July, and the thought behind the question was if we might be at the start of a move that will take the euro back as far as $1.20. I’ve learned in foreign exchange forecasting to never say never and instead view a range of possibilities from very remote to extremely likely. The first thing in this case that I pointed out was that a move to $1.20 would be a fundamentally different forecast from what I have been contemplating, namely a genuine major trend reversal rather than a powerful, but temporary, market correction. A dollar recovery from 1.6038/euro to $1.20 or further means a move of at least 33.7%. While the dollar was very strong in the early 1980’s, advancing on balance from DEM 1.70 to DEM 3.48, there were three downward corrections of 10-15%. Likewise, the euro this decade had appreciated 95% from $0.8228 in October 2000 to $1.6038 in July 2008, but movement along that way was not always upward; there was a 17.4% dollar bounce from $1.367 near end-2004 to $1.164 in November 2005. With hindsight, corrections can be differentiated from major trends by their magnitude. Since a dollar rise of over 33% would be greater than any previous correction of its relationship to the D-mark or euro, one has to characterize such a gain as a key trend reversal and the first such change in at least six years.
Trend reversals may be triggered by market over-supply or other technical signals but eventually require true fundamental economic support. Sheer distance from equilibrium is usually not enough to keep a major trend change intact. The main basis for the dollar rally is not an all-clear sign on the U.S. economy. The first half of 2008 was better than expected from a growth standpoint but worse than assumed on inflation, which is up to 5.6% on the all-items CPI. The Fed has aborted signals in June that it intended to right-size the balance of its priorities between growth and inflation. An increase of the 2.0% Fed funds rate is no longer on the radar screen. The financial market landscape remains very fragile, and a recession is still possible. These two clear-and-present dangers trump the damage of keeping short-term rates at below-inflation levels. But the present policy stance carries potentially huge longer term threats. The United States courted one asset bubble after another and various other assorted macroeconomic imbalances because of overly accommodative credit policy applied too often and too much. Common sense says you do not solve a problem with the same behavior that created the problem. From a U.S. standpoint, I don’t see the kind of structural fundamental changes that can be associated with an enduring and multi-year move that would cumulate to a rise of 33% or more.
Growth is considerably worse in Euroland than had been assumed a few months ago, and its rate of deceleration was very abrupt. That deviation alone was good enough to justify a correction in the euro from clearly overvalued levels. But make no mistake, these are cyclical, not structural, adjustments and by definition self-limiting. The more the euro sinks, the more competitive exports will become, and if the U.S. economy performs better than expected, so will Euroland after a lag. Euroland President Trichet often makes the point that the EMU economy has relatively few major economic imbalances. The inference from that observation is that the exchange rate ought to retain good value as long as the central bank does its job of preserving price stability. There is a tendency, too, to think of the common currency zone as a collection of economies, none of which come near to America’s size or importance. In fact, the sum of the region’s fifteen parts is very substantial and indeed embodies a somewhat larger population than the United States. In one symbolic way, Olympic medals, Euroland took more gold (46) than America’s 36 and more total medals (161) than the 110 won by the United States.
As mentioned at the outset, never say never. Three main downside risks to long-term confidence in the euro are the chance of rebellion by some members to a one-size-fits-all monetary policy, the prevalence of wage indexation in the region, and a population that is aging faster than America’s.
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