Euro is heading for a fall

With the ECB running short of ways to boost recovery, it must resort to QE, which is when market dynamics will turn against the euro

PUBLISHED : Monday, 16 June, 2014, 3:07am
UPDATED : Monday, 16 June, 2014, 3:47am

The euro has defied the laws of economic gravity for too long. The next stimulus step by the European Central Bank should soon clip its wings and quantitative easing should send it crashing back to earth - which means it will get messy for long-term holders of the currency.

For Asian central banks which have built up big hoards of euro reserves in recent years as a deliberate diversification against the weaker US dollar, there will be anxious times ahead. The consequences could be grave.

The euro's strength in recent years is an enigma given a double-dip recession, deflation and a very narrow escape from a nasty euro-zone break-up.

The euro should have been a lot lower by now, especially now that euro-zone interest rates are making an unprecedented dip into negative territory. But it has been like water off a duck's back. The euro seems immune.

Until the ECB begins quantitative easing, the euro zone is effectively running relatively tight monetary policy compared with the United States, Japan and Britain - which have embraced major QE programmes - which means the euro will remain a relatively well-bid currency.

Since ECB president Mario Draghi declared two years ago that he would do "whatever it takes" to save the currency, the euro has enjoyed a resurgence. Investors who took flight in the summer of 2012 have returned to euro-zone asset markets in thick swarms.

Draghi's desperate pledge for euro salvation seems to have done the trick - for now. It gave euro-zone convergence bets an official stamp of approval.

Foreign investors on the hunt for higher yielding investment plays, especially in the formerly distressed markets of Greece, Spain and Italy, have flooded into convergence trades. Going long of euro-zone peripheral bonds and short of German government debt has been a popular strategy.

As convergence confidence rallied, these plays have become quasi-guaranteed one-way bets. Peripheral yields have narrowed dramatically towards German levels. The 10-year Greece-Germany yield spread has sunk to 440 basis points from just under 4,000 basis points in early 2012. Convergence bulls have been richly rewarded.

The portfolio effect has added to the euro's appeal in the past two years as capital inflows from foreign investors have bolstered transactional demand for the currency.

But with the ECB running short of options on how to boost recovery, it must resort to QE. At that point, market dynamics will turn on the euro. As soon as the ECB embraces QE and floods the market with easy money, the euro will go down with all hands on board.

When the US Federal Reserve adopted QE, the dollar lost 20 per cent of its face value. In the wake of QE in Britain, sterling collapsed by 30 per cent. The euro could have a very long way to fall.

A drop below parity for the euro to the dollar seems a reasonable bet over the medium term. Despite a hypothetical boost from QE for high-yield euro-zone investments, a sharply weaker euro could pull the carpet out from under convergence bets.

Exchange rate valuation models suggest the euro is probably overvalued by 15 per cent.

Euro-zone exporters would probably prefer the euro to drop an additional 15 per cent below "fair value" to get the best trade advantage. Once the QE currency bears get the bit between their teeth, a 30 per cent drop in the euro's exchange value could be a self-fulfilling prophecy.

The IMF's Cofer report shows that 24 per cent of global foreign exchange reserves are held in euros. Asian central banks are fairly typical. Central banks that have built up significant currency reserves of euros as a diversification hedge against the weaker dollar are particularly vulnerable.

The ECB could open up the floodgates with quantitative easing. If confidence in the euro starts to wobble and central banks start to panic, the wall of money coming out of the euro could put the currency to rout.

Emerging market holders seem to be conscious of that risk. Since the euro zone began to show signs of stabilising in 2012, emerging market investors have trimmed their euro holdings ever so slightly while advanced economies have gradually added exposure.

The euro may be flying high at the moment, but it cannot continue to defy economic gravity forever.

David Brown is the chief executive of New View Economics