Why isn’t the euro weaker?
Posted by John Forman in Forex, tags: alternative asset, alternative investment, asset allocation, correlation, currency trading, foreign currency, Forex, portfolio diversification, stock market
That’s the question I see popping up frequently of late. The argument is a fundamental one focused primarily on the debt crisis going on in Europe at the moment and the seeming lack of ability of anyone in power to deal with it. Even Federal Reserve member Bullard expressed pessimism about the prospects on a recent CNBC stint. So why isn’t the euro coming unglued?
First of all, as the following charts show, the single currency has been weakening pretty steadily against all the major currencies over the last year.
EUR/JPY is down about 20%. EUR/USD is currently down about 15% from its high, and the other pairs are down a comparable amount. That’s a sizeable devaluation for a major currency in that period of time. So to say the euro hasn’t fallen apart is a bit off.
Could it be worse off? Sure. There are reasons why it isn’t, though.
The biggest reason is what we saw on Wednesday after the release of the minutes of the last FOMC meeting. It indicated the prospect for further QE, or at least further monetary accommodation. This potentiality is present in many of the major economies, while the ECB has dragged its feet being as aggressive as the likes of the Fed and Bank of Japan. We always have to remember that exchange rates are reflections of relative value, not absolute. If the Fed is acting in a fashion which weakens the dollar, then issues with the euro will not be reflected so sharply in EUR/USD.
Those looking at currency valuations also need to realize that unlike stocks and bonds, which are mainly priced in terms of the value of future events, currencies themselves cannot be priced that way. With a stock we look at future earnings and whatnot to figure out what it’s worth today. With bonds we discount back all the future cash flows. In both cases expected future inflation is a factor. Inflation is also a factor in currency valuation, but unto itself a currency has no cash flows to be discounted. As a result, a currency – in spot terms – is a more immediate asset.
The immediacy element means we need to look at the euro more in terms of what it’s being used to buy and sell. The Eurozone as a whole has been running a strong positive current account balance of late, meaning more money coming in than going out. That indicates increased demand for euros, with both trade and investment flows a factor. This is supportive for the euro.
Lastly, also keep in mind the so-called risk trade. The euro has been a primary beneficiary of periods when the markets were more positive about things like economic prospects. As the chart below shows, EUR/USD has been largely well-correlated to the S&P 500.
You may not buy into the euro rallying with stocks, but if that’s what the market does then it’s the reality we have to face at the moment. Regardless, it comes down to making sure we factor in all aspects of the multidimensional forex puzzle, and don’t get caught just looking at one side of any exchange rate equation.
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