Currency watchers have decreed that the euro will fall sharply against the dollar as Europe and the United States’ monetary policies diverge, but history suggests the euro’s drop may not be quite so smooth or rapid.
Frankfurt has started to pump cheap money into the euro zone to try to get banks lending again, boost a stubbornly unwell economy and lift prices currently rising at their slowest in five years. Meanwhile as the U.S. economy revives, Washington is preparing to halt its six-year stint of doing the same.
As a result the euro has fallen nearly 10 percent against the dollar since mid-May. Goldman Sachs predicts a further 20 percent fall to parity by the end of 2017, Deutsche is going for a 25 percent slide to $0.95 and almost every other major financial institution expects further weakness to some degree.
However, patterns in capital flows and market positioning, along with likely opposition from the United States to a surging dollar and past intervention by emerging market countries, suggest, along with lessons from Japan’s 20-year fight against deflation, that this euro-dollar play may not be so simple.
Right now, plenty agree with Goldman and Deutsche’s assessments: On the Chicago Mercantile Exchange speculators amassed their biggest bets against the euro last month since July 2012. Several investment banks say their clients’ positions are stretched.
Barry Eichengreen, professor of economics and political science at the University of California, Berkeley, believes that can only confirm a rethink is due.
“When everyone is lined up on one side of the foreign exchange market, that’s a sure sign that the exchange rate is about to move the other way,» he said.
“Deflation makes for a deceptively strong currency,» explains Eichengreen. «Just as inflation and depreciation go together, deflation and appreciation go together. The parallels with Japan are direct.”
After Japan’s property and stock bubbles burst in the late 1980s, it embarked on a long battle to ward off deflation, rebuild a banking sector crushed by bad debts and revive growth.
That involved Japan’s central bank expanding its balance sheet on an unprecedented scale to flood the financial system with cash – while the world’s second largest economy ran a huge current account surplus, boasted a healthy domestic savings rate and a rapidly ageing population.
All these conditions broadly apply to the euro zone today.
Yet the yen did not weaken during Japan’s two «lost» decades, at least not nominally. It strengthened by as much as 90 percent against the dollar by the end of 2011 and today it is still up 35 percent against the dollar since 1990.
Deutsche dismisses those comparisons.
Back then, it points out, Japan’s central bank wasn’t easing as aggressively as the ECB is now, so liquidity was tighter and real yields were higher. And domestic investors were not deterred Japan’s huge debt: They own more than 90 percent of the Japanese Government Bond market.
However in Europe, Deutsche expects rock bottom investment returns and an annual current account surplus of around 400 billion euros to drive capital out.
The dollar has risen sharply in recent months, as the Fed prepared to end its bond-buying programme this month and the euro zone continued to flirt with a triple-dip recession.
But while the ECB is hoping a drop in the euro could hand it a useful antidote to disinflation and make its goods competitive in export markets, U.S. officials are starting to worry the rising exchange rate could hurt their economy and cause longer-term inflation expectations to move slightly lower.
The minutes of the Federal Reserve’s last policy meeting showed some policymakers were concerned – striking, because exchange rate policy belongs to the Treasury, not the Fed.
“I would imagine at some point the U.S. authorities would stop the dollar from rising. They have already showed some discomfort,» said Jim O’Neill, former chairman of Goldman Sachs Asset Management and a 30-year veteran currency market watcher.
“So while people might hate the euro, they need to remember it is a currency pair, one side of which has nothing to do with Europe. I can’t see the euro much below $1.15 without a much bigger U.S. inflation threat,» he said.
Economists at Barclays estimate that a 10 percent rise in the dollar’s trade-weighted value leads to a 0.4 percentage point fall in the PCE measure of inflation and a similar fall in real growth over the subsequent 12 months.
Other countries’ authorities are also likely to object to a rising dollar and won’t be afraid to act.
Emerging market countries including China, Russia, India, Saudi Arabia and other Middle East oil exporters actively manage their exchange rates against the dollar to varying degrees. They will be extremely sensitive to a rising greenback triggering a rapid rise in domestic inflation.
And since the Asian financial crisis of the late 1990s and the more recent turmoil of 2007-08, many of their central banks have amassed huge foreign exchange reserves in order to cope better with any future difficulties.
According to IMF data global central banks now have reserves of $12 trillion – of which two thirds is held by emerging markets – compared to $1.6 trillion when the euro was launched.
That kind of firepower could prove another curb on what economists say looks less and less likely to be a runaway greenback.