ECONOMETER

The EUR has lost around 23% since it all time high in April 2008 when it traded close to 1.6000. The EUR failed to rally even in the wake of the EUR 750 billion European Union / International Monetary Fund support package, a fact that has highlighted the weight of negative sentiment towards the currency. The latest blow to the currency came from the announcement of unilateral measures from Germany to ban naked short selling on sovereign debt and some financial stocks, actions that only highlighted the lack of policy co-ordination within the eurozone.

The rationale for further EUR/USD weakness is clear and justified partly by growth divergence within the eurozone countries, with Germany on the one extreme and weaker Southern European countries on the other. Moreover, relatively weaker overall growth in the eurozone compared to the US economy, a delay in interest rate hikes by the European Central Bank (ECB) and ongoing concerns about implementation and execution of deficit cutting plans, will also weigh on the EUR.

The EU/IMF support package and in particular ECB interventions in the Eurozone bond market have managed to alleviate some of the strain on European bond markets, but without similar intervention in the FX markets the EUR has become the release valve for Europe’s fiscal and debt problems. As a result the EUR’s fall has accelerated over recent weeks, only showing any sign of stability as fears of currency intervention increased.

The quickening pace of EUR depreciation has led to growing speculation of FX intervention by the ECB and other central banks to support the currency. I believe intervention is highly unlikely and see little reason for panic about the drop in the EUR. Once markets realise that there is indeed little risk of intervention the EUR will resume its downtrend.

One of the main reasons behind this view is that the EUR is not particularly “cheap” at current levels. In fact, “fair value” estimates based on the OECD measure of purchasing power parity (PPP) suggest that EUR/USD is around 5.6% overvalued at current levels, based on an implied PPP rate of around 1.17. Therefore, the drop in the EUR over recent months has only brought it back close to PPP fair value estimates.

Moreover despite the fact that there has been a large nominal depreciation of the EUR its trade weighted exchange rate has declined by much less, around 8.5% since the beginning of the year and around 11.3% since its high in October 2009. Although the trade weighted EUR is around its lowest level since October 2008, taking a longer term view shows that it is slightly above its average over the past 20-years.