US dollar-euro currency expectations

The recent spate of US dollar (USD) selling has inevitably fostered speculation that its 'big' move lower is now upon us. Market sentiment appears to have switched dramatically to the possibility of a 'harder landing' scenario in the US.

This has subsequently damaged the USD but its weakening has been uneven. The USD has suffered more against European currencies than the Japanese yen, which is a direct reflection of investors placing more faith in currencies with stronger growth-inflation dynamics.

EUR-USD last traded above 1.30 in early 2005 but the currency pair then struggled in the wake of the market focusing away from the structural imbalances of the US economy to the cyclical differences between the two economies.

In addition, anti-EU Constitution sentiment and expectations of looming USD positive Homeland Investment Act (HIA) flows helped pressure the euro lower. In early 2005 it was clear the US economy was steadily picking up momentum while domestic conditions in the Eurozone economy were described as sluggish at best. In late 2004 the structural argument for a lower US currency were in place, even though investors believed the cyclical position of the Eurozone economy did not justify EUR-USD above 1.30.

However, this time round the cyclical justification for a stronger EUR-USD has increased markedly due to the combination of stronger euro area growth and because the US economy is slowing.

Comparing US and Eurozone data relative to market expectations demonstrates perception differences between the present situation and the situation in early 2005. GDP differentials clearly show that the Eurozone has narrowed the gap compared to the US. The gap has now fallen to 0.3 per cent due to higher Eurozone growth combined with slightly lower US growth. From the perspective of the national accounts the elevated levels in EUR-USD has more of fundamental justification this time round. Looking forward, this gap is expected to shut completely and go in favour of the Eurozone in the middle of next year, thereby implying that the EUR-USD rate can continue its ascent.

Looking at the employment situation a similar picture emerges. The Eurozone economy has to some extent caught up with the US. While unemployment has moved lower in both economies, the Eurozone's labour market has improved at a much faster rate. With its more flexible labour market it is only natural to expect a lower unemployment rate in the US, but the gap has closed and the momentum seems to indicate this will continue. In this context, EUR-USD levels above 1.30 and higher appear not only justified based on fundamentals, but also sustainable. Also Eurozone industry appears more robust now compared to then.

Looking at core inflation, which neutralises the distorting effects of commodity prices, it is found that while underlying price pressures have remained relatively well contained in the Eurozone, core inflation in the US has rocketed towards three per cent despite a sustained round of interest hikes from the US Federal Reserve.

Accelerated core inflation in the US is not a symptom of impressive growth performance. It is a hindrance to future growth prospects. Conversely, the stable and significantly lower levels of core inflation in the Eurozone provide a somewhat firmer footing for the economy going forward.

Inevitably there remains the question of what this inflation means for interest rates. Despite the elevated levels of core inflation in the US, Federal Reserve interest rate cuts are being forecast throughout 2007. Further hikes would raise the threat of a 'hard landing' scenario in the US, especially given the recent run of disappointing data. Conversely, the ECB interest rate is expected to remain at its current level for a protracted period.

Analysing the relative performance of financial asset classes, the relationship between EUR-USD and the two-year spread between German and US yields seems to be very strong. Looking at this relationship more closely it can be seen that the differential has been on a narrowing trend since June 2006 and as a result EUR-USD has been on the rise. The same effect can be seen when one considers longer dated paper. Euro-denominated investments are becoming increasingly more attractive from a risk-reward perspective. As such relative yields certainly seem to validate EUR-USD's recent upward momentum.

A further case to consider is the comparative performance of Eurozone and US equities. Here the reaction function of the currency in relation to the equity market is crucial. During the tech bubble from 1996 to 2000 the US equity market rose and so did the USD. Here one would argue that the equity market caused USD to rise. However, in more normal circumstances the two markets have a more symbiotic relationship. That is, when USD weakens this is seen as a positive for US equities in aggregate as they become more competitive relative to Eurozone companies.

Undoubtedly the Eurozone is in a far better place now compared to when it previously traded in the present range. Indeed the last time the market pushed the euro above 1.30s (in early 2005) the exchange rate valuation was based on the structural fears relating to the US imbalances. The market then switched from focusing on the structural aspects of the two economies back to the cyclical - which suddenly and dramatically saw EUR-USD fall significantly. From a cyclical perspective it seems that the euro rise will not halt the economic recovery and from a structural perspective there will be no solace for the USD.