INFATUATION WITH STRONG EURO LOOKS TO BE WANING FAST / THE FINANCIAL TIMES GLOBAL INSIGHT ( A MUST READ )

Infatuation with strong euro looks to be waning fast

By Paul Robinson

Published: November 8 2010 15:49
Last updated: November 8 2010 18:14

Fewer than one in five investors expect euro area sovereign debt issues to be resolved without some form of restructuring or break-up of the euro, according to a poll of more than 500 Barclays Capital clients.


Consistent with these survey results, sovereign spreads remain extremely wide, not far off levels seen during the early stages of the crisis in the spring, and in the case of Ireland, considerably wider.


Why does the euro show so few signs of strain? It plummeted as the Greek crisis took hold, but now talk of parity against the dollar has disappeared. Even disturbances in France – hardly a peripheral economy – were met with barely a shrug by FX markets.


Since the latter part of the summer, two factors have driven the dollar lower: weakening US economic prospects and the move towards a second round of quantitative easing.


When the Greek crisis hit, the US was enjoying strong growth while euro area growth over the winter was weak, hardly befitting the word recovery. That changed in late summer. The US slowdown refocused attention on high unemployment, fragile housing and fears of deflation. It helped fuel expectations for QE2 after the August Federal Reserve meeting. This effect has persisted and, though US data have improved over the past month or so, more than 75 per cent of respondents to our survey expect below trend US growth over the coming quarters. And of course the Fed has announced an extension of asset purchases.


By contrast, euro area growth was strong in the second quarter, led by the German economy. A marked slowdown is inevitable, and though the German economy seems robust, growth for the euro area may disappoint relative to the US. But, crucially for euro prospects, the European Central Bank seems to take a different view about the appropriate response. While the Fed has stressed the “unacceptably” high levels of unemployment in the US, the ECB appears to view the recession largely as a structural problem that cannot be resolved by throwing money at it.


The euro has strengthened because of concern about ‘currency wars’. Looser US monetary policy is likely to work partly via a weaker dollar. Uncertainty about the eventual size of monetary loosening, together with the possibility of heightened tension with other economies (and creditors of the US government), has led to capital flowing to alternative currencies. Fast-growing, relatively liquid currencies such as the Australian dollar and the Brazilian real have benefited, but the size of these markets relative to the US economy, and in some cases moves to slow inward capital flows, mean much has also gone to the euro area, again because the ECB does not appear likely to follow the Fed in loosening policy.


Why did the euro depreciate so quickly when the peripheral issues emerged? One reason seems to be the element of uncertainty. No one was sure how the authorities, including the ECB, would respond. Second, it seemed likely to weaken euro area growth. At the time it appeared possible this could be exacerbated by vulnerabilities of euro area banks. Over the past few months these worries have dissipated to some degree.


The concern may have lessened, but it still has substance. Neither the European economy nor the political infrastructure appears to have the flexibility to cope with asymmetric shocks in the absence of any monetary flexibility. Since the crisis there has been little progress. Efforts are being made to resolve the problems, but it will take time and the likelihood of a smooth process seems low. Uncertainty remains.


The crisis accelerated euro area fiscal consolidation. Peripheral economies have made drastic plans, and even the relatively unaffected economies are following suit. The savings rate of the euro area may increase: the profligate will start saving and the abstemious are unlikely to splash the cash.


Euro area domestic demand is likely to remain weak, leading to relatively loose monetary policy. Euro area producers will need to rely more on external demand, which will probably involve a reduction of the relative price of exports. Both are likely to lead to a relatively weak euro. Euro strength derived from the better economic data will probably wane as well. Non-corporate investors have built up large short positions in the euro, which may exacerbate any move.


The FX market sometimes seems like a serial monogamist. It concentrates on one issue at a time, but the issue is replaced frequently. Dollar weakness and US policy have captured its heart. But uncertainties are being resolved: the Fed decision and midterm elections are behind us, and the G20 summit may reduce nervousness about international tensions. The market may move back to an earlier love: the problems that remain in Europe. Euro strength relative to the dollar may be approaching its end.


Paul Robinson is head of European FX research at Barclays Capital


Copyright The Financial Times Limited 2010