The sovereign debt crisis in the euro area worsened in 2011, with serious negative repercussions in real terms as well..……
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Nonetheless, the lows hit by the euro in 2011-12 were much higher than those reached in 2010 (EUR/USD 1.26 vs. 1.18). Similar considerations apply to the yen and the pound. The common factor which explains the unusual behaviour of euro, yen, and sterling, is the (prolonged) zero-rate policy pursued by the respective central banks.
This has been a turbulent start to the year for the euro, which initially dropped from EUR/USD 1.30 to 1.26, and then climbed back to EUR/USD 1.35. The recovery was helped by the longawaited “solution” of the Greek crisis. This prompts the first question: (1) if the Greek crisis is
solved, what will the euro’s drivers be now? The second question is linked with the first: (2) why has the euro shown such downside resilience2, despite the deepening of the sovereign debt crisis, and despite the very survival of EMU being threatened?
As regards point (1), until well into Q1 2012, the dominant overall theme was the sovereign debt crisis, with particular reference to Greece. The repeated postponements of the deadlines set for the solution of the Greek deadlock helped water down risk aversion, which may have otherwise crushed the single currency. Now that the Greek crisis has, so to say, been “solved”, the necessary condition has been met to move on to the next market phase, in which traditional fundamentals should resume their role as drivers, i.e. growth and inflation, and consequently monetary policy expectations/decisions. Based on our central growth scenario for the euro area and the United States, the better expected performance of the latter should penalise the euro in the opening months of the year, and therefore by now also in Q2. From a purely technical point of view, conditions are still in place for a decline of the exchange rate to below 1.30 (downside technical target at EUR/USD 1.26-1.25). The subsequent expected economic recovery in the euro area should then fuel a recovery in Q2, with the exchange rate possibly rising towards the EUR/USD 1.35-1.40 range towards the end of the year/early 2013. The possibility of the Fed implementing a round of QE3 around mid-year should not be viewed as a negative event for the dollar, after a potentially negative impact reaction. The favourable effect the move would have on US growth should ultimately support the dollar and, symmetrically, weaken the euro, either by causing it to temporarily drop, or by compressing its recovery margin. By contrast, if the ECB should need to resort to another interest rate cut, this would probably affect the single currency negatively. It should also be considered that – although the Greek deadlock has been overcome – the sovereign debt crisis in its broadest sense has not been solve, and may re-emerge in certain instances, negatively conditioning the fluctuations of the exchange rate.
As regards point (2), there are at least three sets of reasons that may help explain, at least in part, such a display of downside resilience by the euro.
(i) From a technical point of view, aggregate short euro positions, which have been mounting on the speculative market since August 2011, have reached new historical highs compared to the first Greek crisis in 2010, hitting a peak this year of over one-and-a-half times the high hit in May 2010. Stably large short euro trades played an important role in containing, from a technical point of the view, downside on the single currency, lacking sufficiently serious elements to trigger a total liquidation of sorts of assets in euros.
(ii) From the point of view of macroeconomic fundamentals, broad convergence towards zero interest rates3 in the euro area (Fig. 1), while US rates were already close to zero (Fig. 2), provided further grounds, substantial rather than technical, for downside resilience, as nominal rates cannot drop below zero, and the sensitivity of the EUR/USD to short-term euro yields is positive, and its sensitivity to short-term US yields is negative.
(iii) Finally, operational hedge against the risk of EMU breakup implies a liquidity shift towards countries with more robust fundamentals rather than any capital outflow from the euro area.
We focus here on the relationship between the exchange rate and bond yields (par. ii). To the extent to which rates/yields can provide an idea of growth and inflation expectations, and of the associated monetary policy choices, the correlation between the EUR/USD exchange rate and short-term yields in the euro area and in the US respectively, may be verified and measured.
Using weekly data (averages) from the 2005-2012 period, we have verified the existence of a co-integration correlation (i.e. structural, long-term) between the exchange rate and the aforementioned yields. Based on the estimates yielded by the co-integration parameters, we have obtained a fit that seems to explain rather well the dynamics of the euro in recent years (Fig. 3).
Given the structural nature and the validity of the estimates obtained, they can be used to run a simulation. Therefore, we will assume different combinations of euro and US yields on a oneyear horizon, and project the model to investigate which exchange rate levels are consistent with certain yield combinations.
As shown in the chart (Fig. 4) and in the table below (Table 1), the more euro area yields rise against US yields, the more the euro will tend to appreciate (cases a, b, c). By contrast, the more US yields rise compared to euro area yields, the more the euro will tend to drop (cases d, e, f).
In case (c), i.e. stable euro area yields at their current levels in the next 12 months, and US yields dropping further towards zero, the euro would level off at EUR/USD 1.35, just above its present level (1.32 in the analysis run here). This combination would be compatible with the assumption of stable ECB rates at least until the middle of next year, and with the Fed implementing QE3 in the next few months. Case (b) is closer to our central scenario for the euro area and the United States, which assumes a normalisation on the upside of euro area yields, and a modest, smaller increase, of US yields. Based on this assumption, the exchange rate would rise to EUR/USD 1.39.
Therefore, conditions would be in place for the euro to fall within the EUR/USD 1.35-1.40 range, in line with the prospect of a recovery of the exchange rate towards the end of 2012/early 2013, as described in the closing paragraph of point (1).
On the other hand, the yield combinations proposed in cases (d), (e), (f), stray from our central macroeconomic scenario, and would all imply a drop of the exchange rate from its present levels. The decline would not be significant, to EUR/USD 1.30, in case (d), in which euro area yields converge towards zero, as opposed to a stabilisation of US rates at their present levels. On the other hand, the drop would be sharper, to EUR/USD 1.25, in case (e), in which a normalisation on the upside of euro area yields were accompanied by a much sharper rise in US yields (not compatible with the implementation of QE3 in the months ahead, but not necessarily triggering the start of a Fed rate hike cycle). Lastly, the combination of assumptions envisaged in case (f) would be scarcely credible, with euro area yields rising only very marginally, and US rates soaring (to levels compatible with the start of a Fed Funds rate hike cycle). In this case the euro would plummet to EUR/USD 1.15.
The results of this simulation exercise should not be taken literally, as the estimates used here are derived from a co-integration correlation, i.e. from a long-term correlation, which is purely structural, and does not take into account of short-term adjustments.
In a phase of relative policy rate stability, these estimates provide a good approximation of the fair value of the exchange rate under certain interest rate assumptions.
And if cases (b) and (c) may help place the euro in the 1.35-1.40 range on a one-year horizon based on the hypothesis of our central macroeconomic scenario, case (f) may help explain why (and under which conditions) the euro shows downside resilience.
Indeed, in a context of unchanged monetary policies in terms of policy rates, already respectively at historically low levels (ECB rates) and almost zero (Fed rates), the simulations would show that in order to trigger a substantial depreciation of the euro (to EUR/USD 1.15 in case f) US yields should rise significantly compared to euro area yields, an assumption that cannot materialise as long as the Fed is committed to keeping rates stable at least until around mid-2014.
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