Since January 2015, when the European Central Bank announced its expanded quantitative easing program to stimulate the euro zone’s economy, the euro has fallen sharply against the U.S. dollar. During the first week in March, the sell-off in the 19-nation currency accelerated, after the ECB’s press conference. A subsequent collapse in bond yields saw the euro trade below 1.06 to the dollar for the first time since March 2003. The euro pared some losses a bit Wednesday, rising to $1.10, after the Federal Reserve changed its policy wording. Still, the prospect of parity between the two currencies is on many investors’ minds. What is the chance of such an event, and how likely is a further fall?
Let’s formulate our answer around three questions. Do the underlying facts support the investment case? Is the investment cheap? Are investors buying the investment case?
When we at Investec Asset Management apply our research to the euro, all our short-term indicators continue to suggest a reversal of the euro’s fortune and point to the beginnings of a recovery in the euro zone. First, the ECB recently raised this year’s euro zone growth forecast to 1.5 percent, up from a previous 1 percent. Second, the euro is cheap, trading at about 13 percent below its long-term moving average. Finally, investors have taken a short position. We believe the currency has been oversold in the short term.
Applying the same exercise to the U.S. dollar, our research suggests flatlining economic data, albeit at modestly positive levels. Our data surprise indexes, however, have turned sharply negative, suggesting either that the data are genuinely weaker or that market participants are far too optimistic.
In the medium term, however, the picture is different. We believe the U.S. dollar can continue to rally. The reason for this long-term pro–U.S. dollar view is the same as it was when we first went long in 2012. In our view, the U.S. is in a much better cyclical position than the rest of the world, having deleveraged after the financial crisis. Banks in the U.S. are well capitalized; labor markets are very competitive; interest rates are likely to rise later this year; and, despite the big fall in oil prices, U.S. industry still has a significant energy cost advantage over other countries.
In contrast, the euro zone has yet to see any serious deleveraging and faces years of hard-fought structural reforms to make economies more competitive. This could keep interest rates low and growth subdued.
One point that we shouldn’t overlook is that Europe has achieved monetary union before achieving political union. There are no effective cross-border transfers to aid countries facing economic hardship. This means that those currencies are effectively in an economic construct similar to the gold standard, in which only internal devaluation through lower wages provides a route back to prosperity. This raises the political risks in the medium term — and indeed there has been a recent rise in populist political parties.
It is certainly possible that the euro could fall further and hit parity, but only if our medium-term pro–U.S. dollar view is correct.
Russell Silberston is a fixed-income portfolio manager at Investec Asset Management in London.
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