Euro soaring high

The euro has been reaching record highs recently, both against the US dollar and on a trade-weighted basis. What will stop the euro? There is no doubt that the euro's valuation is becoming stretched. However, this valuation effect is yet to have a significant negative impact on the Eurozone external trade position, so the euro is unlikely to suffer from a rapidly deteriorating current account position.

In any case, the main driver of the euro in recent months has been portfolio inflows in both fixed income and equity markets, so it would be a weakening of these inflows that would be the most likely to damage the euro.

The rise in the euro has not only taken it to record levels on a nominal basis, but also to unprecedented levels on a real effective basis. In the very long run, REERs (Real Effective Exchange Rate) tend to be mean reverting as exchange rates move to compensate for price changes. However, substantial deviations are possible for protracted periods and the euro is now more than two standard deviations above its 1990-1999 average.

On this measure, the euro's valuation is becoming stretched, and this could be taken as a warning sign for its future. The main mechanism by which a currency could come under pressure from this high valuation is through its trade performance. However, for the euro, this does not seem to be a major concern for now. While the balance did deteriorate between 2004 and 2006, the strength of demand in export markets over the past year (especially in emerging markets) has more than compensated for euro strength, so that the trade balance has shown a trend improvement since the beginning of this year.

In addition, official concern about the strength of the euro has been rather limited. While some European officials have worried in public about the effects of euro strength, some have also pointed out that the strong euro is a useful offset to rising US dollar commodity prices. In the recent IMF World Economic Outlook, the conclusion was that "although the euro has strengthened in effective terms, it continues to trade in a range broadly consistent with medium-term fundamentals".

The main drivers of euro strength over the past year have been portfolio inflows in both debt and equity. Debt portfolio inflows have been running at about €150 billion per year, while net equity inflows have been around €275 billion. For the euro to suffer a significant reversal, one or other of these inflows would need to falter.

Debt inflows seem to have been driven by rising Eurozone yields relative to those in other major markets. One obvious implication of this relationship is that anything that sees the yield spread move against the euro would see the euro suffer. While there is little sign that the Eurozone economy is weakening in a way that would see yields fall very much, there is some tentative evidence that, relative to expectations, Eurozone economic activity has been worse than the US.

The strong performance of the Eurozone equity market over the past two years has seen them outperform the other major markets. The strong equity portfolio inflows have been attracted by this performance and (in part) helped cause it. The relative rise in the Eurozone equity market, combined with the strength of the euro, has meant a significant rise in the price of Eurozone equities to overseas investors, especially compared with their domestic markets. While this may be fully justified by prospective earnings in the Eurozone, it is difficult to escape the conclusion that the biggest single risk to the euro would be a significant equity market reversal.

The rise in the euro has taken it to record levels in both nominal and real terms. However, there is little evidence that this is yet having a major negative effect on the Eurozone external trade position, and the euro does not appear to be at threat from either a market or officially induced reversal based on trade or current account concerns.

The major driving force behind the euro has been strong portfolio inflows. Higher relative yields have helped the euro, so a softening of the Eurozone economy that sees this reverse would be a negative. This does not, however, look like a major concern for now. The single biggest risk to the euro would seem to come from the equity market. The euro has benefited from very strong equity portfolio inflows, and a rising equity market goes hand in hand with a rising euro.

Despite all this, it must be kept in mind that Eurozone equities are now much more expensive for overseas investors than two years ago and a significant equity market reversal appears to be the biggest threat to the euro's continued ascent.

This report was compiled by Peter Calleya, manager, corporate strategy and research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.