Ever since the Draghi (“we “ll do whatever it takes’) speech in the summer of 2012, the Euro has had a strong rally versus the dollar, rising from 1.22 to over than 1.36. This rally has recently caught the eye of the ECB who seems to be worried that the strong euro will become a drag on the Eurozone exports growth. Looking at the fundamentals one can make certain observations about the future path of the Euro currency.
The rally is mostly due to the OMT effect with euro breakup risks lowering significantly and inter-euro imbalances, especially in Target2, taking a strong downward path since September. The German Target2 surplus for January is €134.5bn lower than August with the drop reflected on corresponding Spanish and Italian figures as well as on government securities yields. These developments have driven outside investors (for instance MMMFs) to increase their investments in the Euro area, after a long period of reducing their exposure. Flight-to-quality (which is usually bullish for the dollar) has reversed with “risk on” being the main market signal during the last few months.
In terms of interest rate parity, the euro has definitely diverged since the summer. Although the premium of euro interest rates compared to dollar rates (proxied by 3 and 12-month libor rates) is negative (-0.2% and -0.4%, an inverted curve), the euro has strengthened significantly. The chart below seems to suggest a “fair rate” close to 1.25 given the current interest rate differentials:
One of the major positive Euro factors has been the growing Eurozone Extra-Euro trade surplus which has allowed the current account to reach a 1% of GDP surplus in the current 12-month period. Most recent Eurostat data suggest that the strong currency is now hurting exports. Since exports have been the only source of growth for the Eurozone (with internal demand being highly negative), this developments lowers potential growth for 2013 even further (most recent projections suggest zero 2013 GDP growth).
Real economic activity which was -0.6% for the last 2012 quarter, as well as private credit growth and other indicators, seem to be out of sync with bullish sentiments in the financial markets which will have to catch up sooner or later. Moreover, since Euro money market rates arbitrage with the ECB deposit facility rates (due to excess liquidity despite 3Y-LTRO repayments), any further rate cuts by the ECB will only have marginal effects (EONIA rates are already at 0.066% and swap rates lower than 0.15% up to maturities of 1 year).
Overall it seems that the Euro is overvalued based on interest rates differentials, driven by OMT effects but its strength is now hurting the real economy and especially exports. ECB monetary policy cannot have any strong effects (since short-term rates are already close to the ZLB) unless it engages into serious quantitative easing with a view of lowering long-term rates and enhancing the monetary transmission mechanism. It is hard to see how the OMT effect alone can maintain the current Euro strength which will probably have to correct sooner or later.
One should keep in mind that the bulk of the German trade surplus is now with Extra-Euro countries, making the Euro effective exchange rate a key determinant of its external position for the near term future. The fact is that this rate has appreciated substantialy (+5.3%) since mid-2012 after falling 10.4% during 2011 – early 2012 (and 13.6% since 2010):