BET ON THE GREENBACK TO BEAT THE EURO / BARRON´S MAGAZINE ( HIGHLY RECOMMENDED READING )

Feature

SATURDAY, MAY 15, 2010

Bet on the Greenback to Beat the Euro

By KOPIN TAN

Some see the euro sinking to $1 early next year. Where the havens are.

EUROPE'S $1 TRILLION BAILOUT HAS BREATHED new life into the Old World's assets, boosting everything from bonds to stocks. Missing from the celebration, however, is the Continent's common currency, which jumped momentarily above US$1.30 last week, before slumping below $1.24.
Consider that a preview.

The euro, already at a four-year low against the dollar, is likely to go lower. The bold, €750 billion rescue package and broad international collaboration should stabilize European markets and hush the talk of a breakup. Yet that won't stop the currency from careening this year toward the $1.18 level, where it made its 1999 debut.

For a start, the euro's biggest champion -- the European Central Bank -- has caved to political pressure and, among other things, will begin buying sovereign bonds in the market. This transfers the risk of default from fiscally stretched nations like Greece, Portugal and Spain to the euro zone as a whole. And the ECB has to fund it by effectively printing euros, further devaluing the currency.
Stuart Goldenberg for Barron's

A weaker euro will make exports more competitive. But if the euro goes too low, its status as a reserve currency will suffer.

More important, while the bailout buys time for indebted nations, it doesn't make them any more solvent; governments still have to slash budgets despite listless economies. "Spain, Italy and Portugal don't have the same degree of fiscal problems as Greece, but they'll be under similar pressure to undertake fiscal tightening," says Barclays Capital's currency strategist Aroop Chatterjee. "This will weigh on growth in these countries for a substantial period."

The Catch-22: If belt-tightening works, Europe will have to replace waning domestic consumption with foreign demand, and a weaker euro will make exports more competitive. Yet "if fiscal-austerity plans don't work, the euro loses credibility. Either way, the euro weakens," says Marc Chandler of Brown Brothers Harriman.

The interest-rate outlook also favors the greenback. The U.S. may have a knack for keeping borrowing costs artificially low and swelling asset bubbles, but even its benevolent central bank will have to consider raising rates as the economy expands for a fourth straight quarter and as employers hire again. In contrast, a big swath of Europe is grappling with sluggish growth, and Spain is plagued with 20% unemployment (see table below). The ECB can't easily boost rates before the U.S. does.

THE BUCK HAS BENEFITED, of course, from being the fairer of two trolls, and problems with escalating government debt aren't confined to Europe. But the U.S. can print money more efficiently to goose its economy than can a fractious huddle of neighboring nations.

Barclays, for one, sees the euro declining to $1.20 in three months. Longer term, the euro should regain some luster if financial reform succeeds, but the damage to its reputation could prove more lasting. The euro's birth in 1999 gave central banks a viable alternative reserve currency, and over the past decade, the dollar's share of global reserves shrank from 72% to 62% -- while the euro's rose from 18% to 28%. However, during the fourth quarter, even before Greece was "the word," central banks began allocating 71% of new reserves to the buck, up sharply from the third quarter's 48%. That reflected a flight to safety, of course, but the reversal could have legs.

"Large investors will think twice about further investment in the euro, at least until such uncertainties are resolved," notes BNP Paribas' currency strategist, Hans-Guenter Redeker. Most investors have yet to pencil in much weakness beyond this year, and a survey of global banks pegs the euro at $1.30 for 2011. Still, dollar bulls like BNP and Brown Brothers see the euro pushing down to parity, or $1, early next year.

The Bottom Line

The euro is probably headed back to its original dollar-exchange rate of $1.18 this year; dollar bulls say it could reach parity with the greenback by early 2011.

Away from Europe, however, the greenback should continue to struggle, especially against its emerging-market counterparts. "Old safe-haven currencies" -- namely the dollar, euro and yen -- "are getting competition from new safe-haven currencies," says Nomura Securities' Jens Nordvig.

Currencies other than the dollar, euro or yen make up just 3% of global reserves, but their share has doubled in a decade. With public debt at just 48% of projected 2010 GDP in smaller G-10 industrialized countries and 41% in emerging markets, it's no surprise investors are looking there for new safe bets. The Canadian dollar, Swedish krona and Australian dollar are all issued by strong governments in countries with stable inflation and robust economic growth. Nordvig sees the trio as tomorrow's havens.

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