DGAP-News: Silvia Quandt&Cie. AG, Merchant&Investment Banking: In between the lines
(firmenpresse) - Silvia Quandt&Cie. AG, Merchant&Investment Banking / Miscellaneous
15.07.2010 12:04
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Silvia Quandt Research GmbH
Bernhard Eschweiler
eschweiler(at)silviaquandt.de
+49 69 95 92 90 93 51
www.silviaquandt.de
In between the lines
- Euro quo vadis?
- Not much speaks for a weaker Euro versus the Dollar .
- . except for political uncertainty
A random walk or more?
Statistical analysis suggests that most floating currencies follow a random
walk pattern, which means today's exchange rate is the best guess where the
currency will trade tomorrow. This sounds like bad news for currency
strategists and traders. Yet, they are not discouraged to predict and
trade. Are they just gamblers? Probably not all! While most floating
currencies follow a random walk on a short-term basis, they also show clear
trends over longer horizons.
This is also true for the Euro. Its big trend since 2002 was the
appreciation against the Dollar, which had perhaps more to do with Dollar
weakness than Euro strength. That trend ran out of steam with the
financial crisis and many argue reversed with the European sovereign debt
crisis. Largely forgotten are the reasons why the Euro was expected to
rise ever higher. Suddenly, pessimism started to dominate, ranging from
break-up scenarios for the Euro system to forecasts of less than one Dollar
per Euro. Ironically, the Euro recovered again as soon as the last
forecasts had been marked down. Is this a short-term (random) blip or yet
another new trend? Time to look at some fundamentals!
Exchange rate theory is full of models. None is perfect. At best, they
work for a while until something happens that is not in the model. Still,
all the work is not for nothing. The range of models provides a useful
checklist of exchange rate determinants. Without going into the theory,
four basic determinants stand out:
- Purchasing-power parity (PPP)
- Trade balance
- Interest-rate differentials
- Relative productivity
Not so overvalued
Finding the right PPP measure and determining fair value is more an art
than a science. Common perception is that the Euro is overvalued, even at
current levels. A popular measure is the Big Mac Index (BMI) by The
Economist magazine. The BMI suggested that the Euro was at fair value when
it was at parity with the Dollar in late 2002. At its high in 2008, the
Euro was 50% overvalued versus the Dollar according to the BMI. At the
moment, the BMI implies that the Euro is roughly 25% overvalued versus the
Dollar, which would mean fair value is still around parity.
PPP is only believed to hold in the very long-run. In-between, the actual
exchange rate can deviate from fair value. Those periods of over- or
undervaluation are usually marked by trade and current account imbalances.
Interestingly, while plagued by internal imbalances which led to the
current crisis, the Euro area showed no significant external imbalances
over the last ten years (the largest current account surplus was 1.2% of
GDP in 2004 and the largest deficit was 0.8% of GDP in 2008).
The relatively balanced current account of theEuro area also correlates
with a more stable performance of the Euro's real effective exchange rate
(REER, see chart on following page). In trade-weighted terms, the Euro
appreciated considerably less than it did just against the Dollar. Second,
some of the nominal appreciation was offset by lower price increases in the
Euro area versus its trading partners. When the Euro reached its high
versus the Dollar in 2008, it had only appreciated 17% in real
trade-weighted terms since the end of 2002. And that appreciation has been
undone by the Euro's recent fall. In fact, the REER is currently close to
the levels seen last at the end of 2002, suggesting that the Euro is
probably close to fair value.
Watch the policy mix!
Currency movements are not just driven by trade flows. Equally if not more
important are capital flows. A key factor for capital flows are interest
rate differentials between countries. The basic rule of thumb is that a
country attracts new capital inflows if it promises higher returns
(interest rates) and those are not needed to compensate for expected
currency depreciation. In that case the currency is likely to appreciate.
The big moves of the Dollar against the Euro and the Yen over the last two
decades broadly confirm the rule. In the second half of the 1990s and
early 2000s, the Dollar benefitted from higher interest rates and more
broadly the perception of higher market returns. This trend reversed in
2002.
Important for the development of interest rate differentials is the fiscal
and monetary policy mix. If fiscal policy is loose and monetary policy is
tight, short- and long-term interest rates will rise and the currency is
likely to appreciate. A prime example is the Reagan/Volker period in the
first half of the 1980s. Fiscal tightening and loose monetary policy, on
the other hand, will lead to lower money market rates and bond yields and,
thus, weaken the currency. This is the policy mix the Euro area is
adopting, which points to a lower Euro, except that the US and most other
OECD countries are heading in the same direction. The contrast in policy
mixes is becoming more apparent in comparison with Emerging Markets, where
especially monetary policy is tightening to prevent overheating.
More downside versus Emerging Markets
A weakening of the Euro, and probably most other OECD currencies, against
Emerging Markets is also consistent with the growing productivity gap.
Currencies tend to appreciate over time in real terms if their economies
enjoy higher productivity growth. This was true for the US in the
1990s and is increasingly true for Emerging Markets. The main difference
is that most Emerging Markets control their currencies and were reluctant
in the past to let them appreciate. This is gradually changing as the
focus is shifting from export-led growth to domestic-demand-driven growth
and fighting inflation (see China).
Hedge your bets: volatility to remain high
Pulling it all together, the Euro is more likely to trend-depreciate
against Emerging Markets currencies than versus the Dollar or most other
OECD currencies. Silvia Quandt calls for the USD/EUR rate to move in a
range around the current level (1.25) for the next year. The caveat, the
range could be wide and skewed to the downside. The Euro currently
benefits from uncertainty over the US economy, but that could quickly be
replaced by new worries over the future of the Euro system.
A break-up of the Euro system still seems to have a very low probability,
given the political determination to keep the union going. The positive
bond auctions by Spain and Greece are also encouraging, but event risk
remains high. One potential source of trouble is the financial health of
commercial banks in some Euro countries. Of concern is also how bad the
newly adopted fiscal austerity measures will hit growth and unemployment.
Finally, markets will watch closely whether the Euro area will move to a
soft transfer union or reinstall fiscal discipline.
Disclaimer
This analysis was prepared by Bernhard Eschweiler, Senior Economic Advisor,
and was first published 15. July 2010, Silvia Quandt Research GmbH,
Grüneburgweg 18, 60322 Frankfurt is responsible for its preparation. German
Regulatory Authority: Bundesanstalt für Finanzdienstleistungsaufsicht
(BaFin), Graurheindorfer Str. 108, 53117 Bonn and Lurgiallee 12, 60439
Frankfurt.
Company disclosures
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the shares of the companies they cover on an absolute basis using a 6 -
12-month target price. 'Buys' assume an upside of more than 20 % from the
current price during the following 6 - 12-months. These securities are
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Frankfurt am Main, 15.07.2010
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