lunedì 27 luglio 2009

Trend and interest rate push Euro higher

Over the last few weeks the Euro/Dollar exchange rate has moved in line with recent months, with the single European currency strengthening and weakening in the face of rising and declining stock markets. The current uptrend in major international equity indices has coincided with a return of the Euro/Dollar above 1.42, as clear evidence that the Euro/Dollar movement is more contingent on the trend followed by international risk premia than on the two countries’ economic fundamentals. But this trend may prove short-lived as the correlation between currency and equity market movements has often broken down in the past.
Indeed, even though a weak dollar characterised the equity market upswing in the years 2003 to 2007, of opposite sign was the US currency movement against the Euro during the 1990s bull market. Moreover, the early stages of the Euro/Dollar uptick in 2001 also coincided with an equity market slowdown. A number of academic studies have revealed that there is no medium/long-term relation between the trend followed by currency markets and that shown by other asset classes.
The correlation between Euro/Dollar and equity markets might therefore fade in coming months. The consensus of the currency strategists interviewed by Bloomberg is for an exchange rate substantially unchanged during the second half of this year to close 2009 at 1.40. Nevertheless, economists’ forecasts are not unanimous, with the Euro/Dollar exchange rate seen at between 1.16 and 1.55 by year-end.
As clear evidence of how forecasting the Euro/Dollar exchange rate fluctuations is no easy task, the same economists who have made similar forecasts for the Euro/Dollar exchange rate direction have given contrasting views on the reasons behind the emergence of this trend. On the one hand, Jim O'Neil, Goldman Sachs chief economist, sees the US Dollar strengthening over the next 12 months given a potentially better than expected economic climate in the US. On the other hand, Gareth Berry, a currency strategist for UBS, is looking for a US dollar strengthening in the weeks ahead for the opposite reason, namely the possibility that investors’ expectations of an international economic recovery are disappointed.
Nevertheless, many economists, including Jeremy Hale, Citigroup chief strategist, and Steven Englander, a chief currency strategist at Barclays Capital, predict that the Euro/Dollar will continue to move upward going forward. This negative view on the US Dollar is bolstered by institutional investors’ gloomy sentiment on the greenback and by the “uncertainty about the monetary and fiscal policy despite US assurances that the Fed and the Treasury are trying to give the market " says Englander.
Market observers believe that these diverging views on the Euro/Dollar movement might increase market volatility in the months to come.
Confronted with sharply conflicting estimates, investors are finding it hard to take a position. Therefore, analysing the factors that have provided crucial clues about past exchange rate movements may be of help.
First, the interest rate differential. In a recent study published in ("Can we understand the recent moves of the euro-dollar exchange rate"), the economists Brender, Gagna and Pisani have offered evidence that the Euro/Dollar exchange rate moved broadly in line with the Fed’s and ECB’s monetary policy estimates until Lehman Brothers went bust. This correlation might resume in the next few months, leading to a renewed appreciation of the Euro. Indeed, the interest rate differential is expected to continue to favour the single European currency because both a new rate cut by the ECB and a rate hike by the Fed are highly unlikely in coming months. Building a consensus for a rate cut within the ECB is challenging at current market conditions. Furthermore, the Fed is not expected to lift rates in the medium term, even in the presence of an economic recovery, to avoid repeating the mistakes made in 1937, when a suddenly restrictive monetary policy hampered the long-awaited recovery following the 1929 crisis.
Second, the current uptrend could prompt a fresh appreciation of the single currency. In recent years academic studies have shown that "trend following" strategies may lead to a currency market outperformance, as in the case of equity markets. This is confirmed by the moving average analysis, (which nevertheless should be taken with caution due to the short time horizon considered): buy the Euro/Dollar when the monthly close is above the moving average of the last 10 months and vice versa. Since January 1, 1999, this strategy has translated into a 44% increase, with 5 successful transactions and 6 failed operations, against a +25% obtained with a buy and hold strategy. Therefore, opening long positions on the US Dollar until the Euro/Dollar upward trend remains in place seems to be premature.
Although the prevailing short-term view among economists is that a new appreciation of the Euro is on the cards, medium-term projections seem instead to be in favour a US dollar appreciation, as proven by the analysis of the Purchasing Power Parity (PPP) calculated by the OECD. A 2007 report by Deutsche Bank’s economist Bilal Hafeez (“Currencies: value investing”) showed that successful investment strategies can be implemented on the basis of the PPP. Using the PPP calculation, the Euro/Dollar fair value is around 1.17, implying 17% potential for dollar appreciation. Only a sharper increase in US inflation than in the Euro zone could lead the PPP to predict lower appreciation potential for the US Dollar. It should also be noted that when the time comes to tighten monetary policy, rates will likely rise more sharply in the US than in Europe due to the latter’s stronger growth potential.

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