Euro Off to Good Start This Year

January 21, 2011

A firmer euro is arguably the most significant currency market story of this young year.  The euro had gained 5.2% against the dollar at today’s high from its low two weeks ago.  The high of $1.3578 also constituted the strongest level since just before Thanksgiving.  On the euro’s crosses, the euro has recovered as much as 3.0% against sterling, 5.1% versus the Swissy and 5.2% relative to the yen since 2011 lows set on January 10.

Multiple factors account for the euro’s better tone. 

  1. This month’s statement from the European Central Bank was more hawkish than the prior ones.  While retaining the ultra-low interest rate structure for now, officials served notice of a higher state of alertness regarding inflation, which recently exceeded expectations.
  2. During the first half of 2010, analysts were widely predicting a pronounced slowdown of the German economy in the third and fourth quarters.  That didn’t happen, and the January IFO business climate index, which was released today, defied expectations yet again with another improvement.  A healthy Germany is considered better for the whole euro economy on balance.
  3. The euro’s Achilles Heel is the loss of investor confidence in the ability of its peripheral members to service debt and the related possibility that the currency union might split up.  The crux of the problem is arguably more political — difficulty agreeing on how to divide up the cost among governments and creditors — than economic.  It’s hard for markets to fixate on any issue indefinitely, and this crisis is now more than a year old.  When major negative new developments surface, the euro weakens, but this factor seems to have lost the ability to dominate the market all of the time.
  4. The euro has found a comfort zone in the $1.30s since mid-November.  Penetrations into the $1.20s ran quickly out of steam at lows of 1.2918 in the week of December 3 and 1.2905 in the week of January 7.  The mean value of EUR/USD in 2010 was $1.3258 and a high/low range midpoint of $1.3230.  After a fourteen-month crisis over the euro’s future survival, such will close this week above both of those dollar levels.

The euro’s appreciation is not attributable entirely to better perceptions of the currency union.  Confidence in the dollar has also been dented.  The dollar has not benefited consistently from the announcement of several pieces of good U.S. economic news, and it is unnerving when any currency fails to respond favorably to better-than-expected data. When that happens, it is tempting to conclude that the underlying balance of supply and demand for that currency is more adverse at present market levels than generally realized.  In the dollar’s case, the inability to capitalize on good data dovetails with threats by big offshore holders of U.S. currency to diversify portfolios away from the dollar.  Treasury capital flow figures released three days ago seemed to confirm that the threats are not idle ones:  China was a net seller of $11.2 billion of Treasury securities in November, and Opec dumped $3.5 billion worth. 

Until and unless emerging markets stumble badly as happened in 1997-8, it will be easy to get caught up with the view that the pace-setting torch of world growth is being passed down from the United States to the likes of China, India and other less advanced but nonetheless more dynamic economies. If true, this evolution has profound implications for the dollar even if the process is stretched over a generation or fifty years.  Such a shift would be even more meaningful in the long run than the possibility of a defection by one or more members of European Economic and Monetary Union. It remains impossible to hedge enough in a direct manner against a relative loss of importance for advanced economies collectively in the world and America’s leadership among those advanced economies. The capital markets of emerging markets are distorted by regulations and lack adequate depth, breadth and resiliency.  Also, emerging market currencies lack the flexibility of the dollar, euro or sterling.  The Japanese economy has under-performed for two decades for the yen to be a true contender, and gold and other precious metals go only so far in diversifying one’s portfolio, .  Fact is the euro remains for now the only serious rival to the dollar as a reserve currency asset.

The pound’s ability to stay near $1.60 has been impressive and perhaps too much so to last.  Sterling has two strengths:  a government with the will and ability to tackle long-term fiscal problems and a greater potential in the near term for a central bank rate hike than found in other advanced economies.  However, these supports exist because of deep pre-existing fundamental problems.  Britain is the one advanced economy with genuinely excessive inflation.  Officials have lost credibility in predicting inflation, and the U.K. has a tradition of letting serious inflation in the back door.  When in the wake of OPEC 1, inflation spiked to 9.4% in the United States and 5.9% in in Germany by mid-1975, such was cresting at 26.1% in Britain.  In March 1980 during the second oil price shock, inflation stood at 5.8% in Germany, 14.6% in the United States, and 21.3% in Great Britain.  Again in October 1990, when inflation crested at 6.3% in the United States, 3.9% in France and 3.3% in Germany, Britain’s on-year pace was 10.9%.  U.K. exports haven’t benefited as much as one might expect from extensive sterling depreciation during the world recession, even as domestic demand is poised to flatten because of fiscal restraint to fix a double-digit deficit/GDP ratio.  The pound is at present slightly above its average 2010 values against the dollar and euro.  Both of those conditions are unlikely to persist throughout 2011.

The extreme nearness of both the Canadian and Australian dollars to U.S. dollar parity also seems temporary  on technical grounds.    Unity holds enormous psychological importance in any currency pair.  As recently as November, the Swiss franc was trading very near to dollar parity, but it has now moved away from one-to-one to settle on the franc-stronger side in the mid-nineties.

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.

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