The euro will fall by a further 10% against the dollar and reach parity with the US currency within a year.
Why do I say that, when most of the world expects the new currency to strengthen against other major currencies? Well, partly for that very reason – the euro is over-owned. When everyone stands on the same side of a boat, it capsizes. And right now, everyone is standing on the same side of the euro boat – the long side.
And little justifies this confidence in the euro vessel. First, US growth will boom as long as the equity market stays up. In contrast, the euro zone is heading for a growth recession. So the Federal Reserve won’t cut interest rates, but the European Central Bank will.
Second, budget deficits in Europe will disappoint expectations as growth slows. And European politicians will make sure the economic & monetary union’s stability pact is inoperative. One of the key foundations of Emu was the pact’s ability to keep budget deficits very low over a full economic cycle. It is supposed to penalize euro governments that fail to keep their deficits below 3% of GDP. But who’s going to stop the likes of Italy or France breaching that limit in order to revive growth or put a cap on rising unemployment? The pact will be shown to be worthless.
This combination of weak fiscal and monetary policy will drive the euro down. Higher wages might also blow away low inflation expectations. After all, Europe is much less of a consumer-pricing paradise than the US. But there’s no way the politicians will allow the European Central Bank to raise interest rates if the EU unemployment queue is growing (you can forget the ECB’s nominal independence).
The result is that both bond and equity markets in the euro zone will do badly and capital will leave Europe. These are hardly arguments for being long the euro.
On the other side of the coin there’s the argument for a strong dollar. It concerns external deficits. In a world where liquidity for high-risk borrowers is tightening and hedge funds are tamed, scarce capital means that countries with big current-account deficits will have weak currencies. As there won’t be enough capital around to finance these deficits, they will have to contract their economies in order to balance the books.
That certainly applies to emerging markets. And the dearth of risk capital will also hit Japan for a few more months, at least until the government is forced to choose between letting Japanese government bond yields go to 5% or the yen to 160 to the dollar. That’s what the tough decisions about monetizing the deficits of Japan’s bankrupt state are all about.
But the logic about external deficits works in reverse for the US. If the emerging world is being forced to run current-account surpluses, that means the capital accounts of these countries will move from surplus into deficit.
The biggest swing this year will be in Latin America. Last year, the positive swing in the current accounts of non-Japan Asia was worth about $80 billion. This year, the current-account surplus of the Asian crisis countries will shrink a bit, but their central banks won’t be selling dollars to defend their currencies. Indeed, they may turn net buyers again.
Now if Europe and Asia are going to continue exporting capital, where will it go? You can bet that it will be the US that will be the lucky country able to run a big current-account deficit financed by capital inflows from the rest of the world. For one thing, real yields on 12-month paper in the US are substantially higher than elsewhere in the “low-risk” world.
The US capital-account surplus will become the flipside of the growing emerging-market current-account surpluses. So I see no problem in the US continuing to finance its growing current-account deficit with increased private foreign capital inflows.
All the other arguments for being long the euro rely on critical mass. The logic runs that the euro area is big in international trade and as a proportion of global financial asset markets, so foreign central banks, corporations and individuals will diversify into the euro.
Well, history is littered with examples of big, dud currencies. If the policymakers don’t run Europe right, that could be the euro’s fate too. In any case, the switch of assets and business from the dollar into the euro is likely to take a very long time.
For example, if we assume that Asian central banks switch 10% of their dollar holdings into euros over five years, that would make for an annual capital outflow of $8 billion for the US. That compares with annual average private-sector capital inflows to the US of $100 billion a quarter in 1998. There are just too many other variables to make central bank foreign-exchange diversification a determinant of the dollar’s strength or weakness.
A greater worry is the risk of a collapse in the US equity market that would cause a coitus interruptus for foreign capital inflows. Here, admittedly, there is an apparent inconsistency in my position. I’ve argued before that the US equity market is overvalued and going to collapse and when it does, so will the economy and the dollar.
But when global equity markets tank, Europe’s won’t go unscathed. And maybe the historical link between the dollar and the Dow Jones will break down. Instead, the world will rush to buy US treasuries, encouraged to do so in the certainty that the Dow’s collapse means no US inflation. Then the dollar will stay strong.
David Roche is president of Independent Strategy, a research firm based in London.
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