Seeing is Believing

March 28, 2013

Speculation about moving to a one-to-one dollar per euro exchange rate has again surfaced.  Ezone difficulties seem much more formidable than America’s problems, and they are complicated by the institution of a common currency that lacked proper political legitimacy at its inception and still does.  The Economist has summed up the present state of European Economic and Monetary Union with the following brilliant simile: “It feels more like a loveless marriage, in which the cost of breaking up is the only thing keeping the partners together.”  Those costs will be no higher one, five or ten years down the road than they are now, whereas the costs of staying together will mount unless measures are taken to arrest the forces that are driving a wedge between the few members that are competitive and those that are not.  A substantial depreciation of the euro seems like the inevitable long-term fate whether the common currency survives intact or breaks apart into several pieces.

Dollar parity with the euro has seemed more plausible by the day since the European debt crisis began in the autumn of 2009.  Par wouldn’t even be unchartered territory.  The historical low of the euro of $0.8228 set in October 2000 was almost 17% below the 1:1 threshold.  The all-time average value of the relationship since the euro was launched in 1999 is $1.2129.  The euro is presently seven cents stronger than that mean despite much direr fundamentals than experienced earlier in its life.  While the end of Europe’s recession keeps gliding further into the future, the U.S. recovery that began in mid-2009 continues to broaden slowly but surely.  The two areas that had to improve to make this a sustainable upturn, housing and the labor market, are now picking up momentum.

Nonetheless, I’ve been burned before thinking the euro had run out of gas and prefer to take a “seeing is believing” approach.  The two big runs against the yen during the past four years went no farther than $1.1878 hit on June 7, 2010 and $1.2041 reached last year on July 24th.  Neither of those troughs is far from the aforementioned lifetime mean in the euro/dollar relationship.  If this were a basketball game, all the action is happening in the dollar’s half of the court, and it’s tough to win when playing defense all the time. 

A comparison of the monthly averages in EUR/USD over the fifteen months and five quarters since January 2012 highlights the astonishing stability of this most important of all currency relationships.  The table below documents these monthly means.  Row one, two, and three refer to the first, second and third months of each quarter.  Outside of the three-month sequence June-August 2012, all of the monthly means were confined to a narrow $1.280 – $1.334 corridor.  The most recent monthly mean is a mere penny apart from the mid-point of that range.  The euro debt, banking, and growth crisis has been long already in duration and full of very scary moments, excuses if you will to short the common European currency, yet the essential trait of EUR/USD movement has been stability, not trend.  It’s been a very well-centered relationship thus far, and its fair to wonder why the future should be different from the past.

$ per EUR 1Q12 2Q12 3Q12 4Q12 1Q13
One 1.290 1.315 1.239 1.297 1.330
Two 1.323 1.280 1.255 1.283 1.334
Three 1.320 1.254 1.285 1.313 1.296

I’m also skeptical of very bearish euro forecasts because they imply a quite bullish view of the dollar.  Until now, there hasn’t been room for more than one fiat currency to hold the high ground in reserve asset portfolios.  Sterling once laid claim to that title, and the dollar has owned it since the Second World War.  The dollar is the champion, and the euro is its only serious challenger right now.  The yuan may move into contention some day, but much would have change first beforehand.  The point here is that it’s difficult to think conceptually about sustained euro weakness without accepting that such a period will be also one of sustained substantial dollar strength, and such episodes happen seldomly.  There have been just two significant instances of multi-year dollar appreciations, the first in 1980-84 and the other in the latter 1990s, and each was emphatically reversed afterward. 

If I’ve learned one lesson from my career as a foreign exchange analyst, it’s not too get too enamored of the dollar.  I began this journey exactly 38 years ago, when like now Easter fell on the cusp between March and April, 1Q and 2Q, and one Japanese fiscal year and the next.  My first day in the New York Federal Reserve’s Foreign Department was March 31, 1975, and it was Easter Monday.  The dollar had floated just two years earlier but already showed massive net losses from its pre-August 1971 levels.  In the ensuing 38 years, nonetheless, the dollar has on balance declined by 68.0% against the yen, 62.6% against the Swiss franc and 34.9% against the D-mark translation value of the euro.  It’s even 2.2% weaker against the synthetic French franc.  Of those entire 38 years, exactly 5/8ths of the period occurred before the euro was formed. The dollar fell 28.7% against the D-mark between March 31, 1975 and December 31, 1998 and another 8.6% on balance against the euro since the start of 1999.  The one major currency against which the dollar rose sharply over the past 38 years was sterling, which was valued at $2.4090 at end-1Q75.  The dollar is now 58.6% stronger, and that is very telling. 

Having the dominant international reserve currency bestows tremendous advantages on an economy, but that role does not promote strength in market-determined exchange rate values.  Enormous offshore holdings of the money that is a reserve asset are created, and the associated weak bias of the currency against other monies continues even if the status of reserve asset kingpin is taken away.  Both the United States and Britain run chronic current account deficits.  That’s not a coincidence, and current account deficits are a negative economic fundamental in the determination of currency values.  Britain’s current account shortfall jumped to 3.7% of GDP in 2012, the largest such ratio since 1989.  The U.S. deficit was around 3.0% of GDP in each of the past two years.   A sustained multiyear dollar rise would probably be associated with a much smaller current account imbalance. It would not be welcomed by U.S. monetary policymakers until they are satisfied that unemployment is sufficiently low and inflation risks outweigh deficient growth risks.  Such a shift at the Fed remains some distance away.

Analysts anticipated a sharp decline of the yen next month when the Bank of Japan is expected to announce aggressive further quantitative easing.  But the yen rarely gets hammered in April, which seems counter-intuitive because the start of a Japanese fiscal year frees Japanese investors to redeploy assets overseas. In the 24 years from 1989 to 2012, the yen fell in April by 1.0% or more just five times, the last being in 2008.  In subsequent years, the yen ticked marginally lower against the dollar in 2009 (0.2%) and 2010 (0.5%) but rose by a solid 2.6% in 2011 and an even more impressive 3.0% in 2012.  Will yen history repeat or be overwhelmed by BOJ Governor Kuroda’s agenda?  It’s another reason to drop pre-conceptions and believe what you see, not what common sense suggests.

Copyright 2013, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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