No Wind in the Euro/Dollar’s Sail

August 4, 2016

The most significant bilateral paper currency relationship from both an economic, political, market-trading and psychological standpoint is the EUR/USD.  Before the euro was introduced at the start of 1999 when many countries in Europe more or less linked their currencies to the mark, that role involved the exchange rate between the dollar and Deutsche mark.

The populations of the United States (318.8 million) and Euroland (318.9 million) are somewhat similar. The United States accounts for 16% of global GDP, and the euro area’s share is 16%.  Japan, by comparison, contributes about 4% of world GDP. While China’s share is similar to America’s, China is an emerging market with a much lower per capita income than the U.S. and a currency with limited offshore holdings and that doesn’t fluctuate freely according to shifting market demand and supply.

In its whole history of nearly 18 years, the euro has traded as weakly against the dollar as $0.8228 on October 26, 2000 less than two years into its existence and as strongly as $1.6038 on July 15, 2008 during the Great Recession. The pair’s average value over the entire period is $1.2153, so the dollar is currently 9.1% stronger than the mean.

There have been times of rapid cumulating change in the EUR/USD relationship.  As one recent example, the sequence of monthly averages over the nine months from June 2014 to March 2015 was $1.360 in June, $1.354 in July, $1.332 in August, $1.290 in September, $1.268 in October, 1.247 in November, $1.232 in December, $1.162 in January, $1.135 in February and $1.083 in March.  The dollar’s average value in the final month of that span was 25.6% stronger than its mean in the first month, and the dollar advanced in each month of the streak.

More recently, in contrast, EUR/USD has behaved like stranded boat at sea with no wind in its sail. The euro averaged $1.1036 in the second half of 2015 and 1.1% higher at $1.1154 year-to-August 4 in 2016.  Since April 2015, the euro’s strongest monthly average against the dollar was $1.134 in April 2016 and its weakest was $1.081 in April 2015. On each of the first four trading sessions of this week, the high-low 24-hour spread in EUR/USD was no greater than 0.736% and as slight as 0.242%, with an average high-low daily range over the four days of 0.50%.

Economic fundamentals in the two economies are not so identical as to justify such listlessness in EUR/USD movement. Economic growth, to be sure, will be similar this year but the U.S. is expected to grow almost twice as fast the euro area in 2017.  Inflation in both economies is presently low but expected to trend higher in 2017, and the U.S. level will stay about a percentage point above Euroland’s trend. The U.S. has a current account deficit of around 2.5% of GDP, while Euroland enjoys a surplus of approximate similar relative size to GDP.  Their budget deficits are lower than 2% of GDP in the U.S. case and about 2.5% of GDP in Euroland’s instance. Monetary policies at the Fed and ECB are not synchronized. Fed officials expect to be raising rates gradually and patiently. Their ECB counterparts have a negative interest rate that will be no higher than now in the forecast horizon and is being supplemented by quantitative stimulus and other non-standard monetary schemes to ensure that the economy doesn’t drift into deflation.

Maybe the biggest explanation for the currency’s calm is the high level of uncertainty on both sides of the Atlantic. Americans will be electing a new president in three months. Both major political parties have made fair trade a key campaign promise, and Donald Trump would be a president like no other in the history of the Republic.  To coin another Republican’s popular phrase, Trump as president would release a load of unknown unknowns, since the only consistency to his campaign is the drive to be as inconsistent as possible in every respect.

Euroland is coping with critical unknown unknowns and known unknowns as well.  One is the health of its banks and banking system and whether such can tolerate a big shock. Another is the impact of negative interest rates over the long term, and a third is the coming spillover of Britain’s journey out of the European Union upon the remaining members.

The uncertainties faced by the United States and Euroland have frozen EUR/USD in a suspended state of wait and see.  Uncertainty has been a fact of financial market life since 2007, so it’s not a convenient excuse for explaining a lack of action in the most significant currency relationship.  And in fact, there have been instances of considerable volatility during the past decade of high uncertainty.  Perhaps the mother of all unknowns is the identity of what news will wake EUR/USD up from its current slumber.\

Copyright 2016, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.



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