Euro Badlands

March 13, 2014

The euro area economy needs a strong and strengthening euro like a hole in the head.  Three straight quarters of positive but sluggish expansion has lifted GDP for the whole region to a mere 0.5% above its year-earlier level, and the shortfall from the pre-Great Recession peak is even greater.  Germany’s on-year growth of 1.4% was responsible for over 70% of the 0.5% pace.  The rest of the euro area collectively grew some 0.15% during the last reported four quarters, well below escape velocity. 

Weak and uneven growth can create future growth depressants.  Euroland’s negative output gap, the spread between actual GDP and what GDP would likely be if all productive resources were utilized, is apt to get wider.  Current account disparities between surplus countries like Germany and the Netherlands and economies running deficit are at risk of widening further.  Pockets of deflation may intensify, generating self-fulfilling expectations of falling prices in the short term.  When the euro appreciates, import prices cheapen and the competitiveness of exports and and import-competing goods is eroded. 

The euro was launched at end-1998, weighing in at just over $1.17 and has traded above that birthing weight more often than not.  Earlier today, the common currency strengthened to within 32 pips of $1.4000.  That level has not been breached a lot.  The threshold was last exceeded on October 31, 2011.  And over the 15 years and 3 months of its existence, $1.40 and above has proven to be pretty rarified air, happening only marginally more than 14% of the time compared to 51% of the time when the euro traded between $1.2000 and $1.3999.  Incidentally, the euro has exceeded $1.5000 for less than 3% of its lifetime.  Although the all-time mean of EUR/USD lies at roughly $1.22, the euro has been above that center of gravity about two-thirds of the time.  The weakest euro levels were front-loaded as the common currency struggled to gain acceptance and as much credibility as an inflation-fighter as the Germany Bundesbank had enjoyed previously.  The euro, whose all-time low of $0.8228 was touched on October 26, 2001, has been weaker than $1.20 in only about five months of the last 10-1/3 years.

The euro is buoyed by a number of factors.  First, while growth is weaker than in the euro area than in the United States, Europe has done a better job of outperforming analyst and investor expectations during the past year.  Second, fear that the common currency will break apart from debt, growth, and political strains continues to dissipate.  This can be seen in shrinking differentials between various 10-year bond yields and the yield on German bunds.  In the table below, Greek, Portuguese Spanish, Italian, and Irish 10-year spreads against German bunds are shown for July 25, 2012, January 15, 2013, September 20, 2013 and March 12, 2014.

# of basis points 07/25/12 01/15/13 09/20/13 03/12/14
Greece – Germany 2,608 1,015 832 546
Port. minus Germ. 1,016 490 520 290
Ireland – Germany 511 287 193 144
Spain – Germany 615 355 236 175
Italy – Germany 519 269 247 181


Third, the market currently worries that the Federal Reserve may be erring in not tightening policy quickly enough, and the benefit of forward guidance as a policy tool does not enjoy widespread acceptance.  In contrast, a belief shared by many exists that policymakers at the European Central Bank are running a policy that is too tight, posing some risk of the region sliding into deflation.  Contrary to common sense, mild deflation actually promotes currency strength as seen in the yen’s earlier experience.  In an earlier blog post, I presented evidence that ECB policy appears to be influenced disproportionately by German economic and price trends.  Fourth, confusion about U.S. foreign policies may also be weighing on the dollar’s main relationship, which is its value against the euro.  The fifth factor is Euroland’s widening current account surplus set against a U.S. deficit that has plateaued.  Sixth but not least, reserve asset diversification waxes and wanes but is always present, and it favors other currencies against whatever currency happens to be the dominant international reserve currency asset.

One likes to think that market forces promote the outcome that maximizes the difference between good results and bad ones, but currency markets have little altruism in their fiber.  From a growth, inflation, and balance of payments standpoint, the members of the euro area would be better served by a weakening euro than the strengthening one that has been experienced.

Copyright 2014, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.



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