EUR/USD – Echoes of 2002

EUR/USD has bottomed out for the foreseeable future. At the beginning of the year I thought we might have another go at breaching parity on the back of further expectations of Fed tightening spurred by expectations of stimulative fiscal policy (and possibly protectionist measures) from Trump. The downside was nevertheless quite limited because the EUR was starting from very undervalued levels from a long-term perspective. Dips to parity even then looked likely to be a long-term buying opportunity. But with the break above 2015 and 2016 highs seen in July, the base looks to be confirmed technically, and the chances of a dip back below 1.05 – or even 1.10 – now looks like a long shot. The picture now looks quite similar to 2002 when the break through the 2001 and 2000 highs was the start of a 6 year rally of more than 70 figures to the highs in 2008.

Euro bears will be inclined to point out that the EUR was a lot lower then, but in reality the situations are not that different. In 2002 EUR/USD Purchasing Power Parity (according to the OECD) was around 1.17. Now it is 1.33. So, as the chart below shows, the difference from PPP at the lows in 2000 was not that much greater than it was at the lows in January this year. A little over 30 figures then, just under 30 figures this year.

eurusd and ppp

Source:OECD, FX Economics

Then, as now, the rally in EUR/USD frankly looked overdue. The case for the extreme USD strength in the early 2000s was based on a combination of the safe haven status of the USD, the uncertainty about the viability of the newly created EUR and the fallout from the 2000 crash. But by 2002 the major economies were all in the process of recovery and yield spreads, which are usually a reliable determinant for EUR/USD (and its precursor USD/DEM) were suggesting EUR/USD was substantially undervalued. Things are different now in that the yield spread doesn’t show a clear case for a higher EUR (though the US yield advantage is less clear when looked at in real terms).

eurusd and tnotebund

Source: Bloomberg, FX Economics

However, whereas the Euro area then was a region which only had a broadly balanced current account, it now has a massive current account surplus of around 4% of GDP (similar to the US current account deficit at more than $400bn). In the past couple of years this has been more than offset by portfolio and direct investment flows out of the Eurozone, and reports suggest that sovereign wealth funds have substantially reduced EUR weightings since rates turned negative. However, with monetary accommodation now looking more likely to be reduced, and European equities looking considerably cheaper than those in the US, these capital flows may well start to reverse before long.

This doesn’t mean EUR/USD is about to embark on a 70 figure rally over the next 6 years (as it did in 2002) and hit 1.75 in 2023. For the recent recovery to extend much further we are likely to need a significant narrowing in yield spreads, and this may still take some time as the ECB aren’t likely to be in a big hurry to remove accommodation. It is unlikely that the ECB are going to be too concerned about the run up in the EUR seen so far – it is quite minor on a multi-year scale, and the EUR remains quite cheap by long-term standards, but the pace of recovery may be a concern, because that will impinge on inflation in the short run. This could slow any ECB tightening, but the ECB must accept the likelihood of a long run EUR recovery. Nevertheless, EUR/USD should now be seen as a buy on the dip from a long term perspective. 1.10 looks unlikely to be breached again, so anything near 1.15 should be a buying opportunity.

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