How Likely is EUR/USD Parity in late-2010?

May 14, 2010

None of the efforts made so far to end Europe’s sovereign debt crisis has produced lasting relief, and it’s doubtful that anything will be done to defuse this bomb soon. In the wake of a wrenching recession in the region, the worst since the Second World War, it will be extraordinarily difficult to secure voter acceptance of the deep budget cutbacks that the situation requires.  That is especially so due to the perception that austerity is being mandated to fix the mistakes made elsewhere in the region.  Without fiscal cuts and other structural reforms, throwing money at the problem creates new debt to treat debt and does nothing to restore competitiveness of Europe’s peripheral economies.  When the money is used up, the region will still have substantial economic problems including a larger debt-to-GDP ratio than now.

The imposition of austerity, assuming political opposition can be overcome, isn’t enough.  Raising the relative competitiveness of Greece, Portugal, Spain and other countries that need that to happen can be accomplished either by currency depreciation or a comparative drop in unit labor costs via productivity gains and falling inflation-adjusted wages.  Participation in the common currency removes depreciation from the option menu.  Euro depreciation will not affect export competitiveness rankings within the currency union, which is what the peripherals really need.  Austerity will drain tax revenues, leading to more budgetary red ink.  Meanwhile, Germany sets a tough standard for the other union members.  The peripheral nations can only recoup competitiveness versus the bloc’s largest member to the extent that they out-perform Germany.

The European Central Bank was conceived in the image of ultimate guardian of the euro — both its interval value by maintaining low, stable, and predictable inflation and its external value by not allowing cumulating depreciation.  To carry out this mission, the central bank was granted extreme independence, and it had a set of principles that were met vigilantly until this crisis.  In a string of falling dominos, these standards have been compromised, and dissension within the ECB Governing Council has been aired publicly, which hardly ever occurs.  The hard currency reputation of the euro and its ancestral D-mark were built foremost on central bank grit, protected by a fortress of enshrined independence.  These have  been tarnished possibly irreparably

Investors are concluding that the crisis can end in only one of two ways.  One would be a break-up of the common currency, which would be very messy and fraught with uncertainty and logistical difficulty.  The other scenario would seemingly need to see an integration of the region’s fiscal policies and eventual major restructuring of several countries’ debt tantamount to default.  The real point of assembling a far bigger-than-expected war chest of resources announced at the start of this past week was to convince investors that default of anybody is impossible in 2010 or 2011 and to buy time to implement necessary reforms and demonstrate a credible long-term strategy of restoring public and private debt to sustainable paths.  This approach was not balanced, however.  The markets were duly impressed by the magnitude of the liquidity offer but left disappointed because of all the squabbling by negotiators and interest groups and the lack of concrete structural reforms.  The final straw has been the realization that northern Europe’s banks are terribly exposed to any renegotiated sovereign debt.

It’s important for analysts at times like these to think outside the box.  Since much political capital has been invested in Europe’s currency union, the situation probably needs to deteriorate considerably further before countries pull out.  Other options need to be tried and discarded before that happens.  One possibility is coordinated intervention to support the euro, which last occurred when Bill Clinton was president.  Europe’s problems are now threatening market conditions well beyond its borders, putting the whole global recovery in some jeopardy.  Movement in the euro over the past seven trading days appear disorderly.  From $1.2518 on May 6, the euro climbed 4.6% to $1.3093 on May 10 but then lost 5.6% to $1.2356 earlier today.  Against the yen, it rapidly soared 10.7% from 110.5 to 122.3 but subsequently plunged 7.2% to 113.46. 

Even if intervention could arrest the euro’s decline, unsupportive economic fundamentals point to eventual further losses, but the amount of incremental depreciation over the coming six months may be less than realized.  Over the euro’s entire life span, EUR/USD has had an average value of $1.1830, a weaker level by 4.3% than today’s low.  The level of the euro is not at an extreme; it is the rate of drop, not the rate level, that may be pushing the limit before long.  At today’s low, the euro had lost 18.4% since the 2009 high in late November.  Alternatively, the dollar has risen 22.6% in this span of just under six months.  It is fairly rare for the dollar to post a 12-month move against Europe’s main currency that exceeds 20%.  It is extremely infrequent to see a 12-month move of more than 30%.  Over the ten and a third years since Y2K, the euro’s sharpest incline against the dollar over any 12-month period was 29.3% in the year to May 27, 2003, and the dollar’s sharpest advance against the euro was a gain of 28.4% in the year to October 19, 2000.  During the previous dozen years, 1988 to and including 1999, the dollar’s largest 12-month rise was 27.2% on April 6, 1997, and the mark’s greatest one-year climb was 29.7% in the year to April 25, 1992.  Earlier years of 1977 to 1987 saw the dollar gain 45.4% against the mark in the twelve months to August 10, 1981 and the mark soar 57.7% in the twelve months to February 27, 1986.  For periods of dollar strength, moves of 30% or more were seen only between late May 1981 and late September of that same year.  America was in a deep recession, but monetary policy was as tight as you’ll ever want to see it because CPI inflation was hovering at 10%.

The euro needs to be at $1.165 or weaker in the final week of November for the dollar then to record a 12-month gain of 30% or more.  While only 6% away from today’s dollar high, It would represent only the second 12-month dollar rise of that much or more in at least 34 years.  Note that I’m not saying there might not have been other instances when the dollar rose by at least 30% over periods of less than 12 months only to fall subsequently to below that threshold before a rolling 12-month span of time was completed.  Perhaps the euro will sink below $1.165 sometime between now and late-November.  From the standpoint of the market’s mood today, that looks very plausible, even probable.  Investors simply have to be aware that cumulative dollar appreciation against the euro since November is already quite extensive, raising the chances of a counter-trend correction sometime in the next six months. 

In that regard, talk of euro/dollar parity later in 2010 presents a conundrum.  That’s still a climb of some 24% for the dollar, and those kind of moves generally do not happen in a few weeks or months.  It would likely take at least a half-year.  Parity  in the final week of November would constitute a 51.5% 12-month advance, not far away from the 57.7% rise of the dollar between February 27, 1985 and February 27, 1986.  However, at DEM 3.478 in late February 1985, the dollar was extremely overvalued across the board, and G-7 central banks would be intervening heavily during the ensuing year and issuing the Plaza Accord agreement that told investors that they would do whatever it took to promote a weaker dollar.  So the euro seems to be caught between the proverbial rock and a hard place in the short term, but a sustainable further decline to par with the dollar this year is not consistent with most historical experience.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.



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