Up until the middle of last year, I thought it was fairly clear which way the euro was heading against the dollar. After almost three years of lurching from crisis to crisis, breakup of the eurozone was a frequent topic of dinner time conversation (my 8-year old reluctantly included). It was fairly clear that to short the euro was a pretty safe bet, even if it was the consensus view at the time.
But then came along Draghi at the end of July 2012 to say he would do "whatever it takes ... and believe me, it will be enough." Not quite Hollywood, but that's a pretty good script for a central banker. And, as you can see from the graph below, the market believed him. The saying "don't bet against the Fed" was unceremoniously dumped from its number one place in the trading rule book as the markets took Draghi at his word.
(Click to enlarge)
At this stage (if it's not too late), I'd like to say that I never advise anyone on outright currency positions as part of a portfolio allocation. Sure, hedge your overseas allocation (if you hadn't, your 25% return on the Nikkei last year would have "just" been 12% in USDs). But, short-term outright FX positions don't have a place in any respectable medium-term diversified portfolios, unless you just want to take a punt. I'm with Alan (Greenspan, that is) all the way when he said,
"There may be more forecasting of exchange rates, with less success, than almost any other economic variable."
But still, it seems to me that the last few months since Draghi uttered those words, has been a fine illustration of the rule that the FX market is like a small child - it is only able to focus on one thing at any one time. So, the past six months the market has relished the fact that is has a story to hold on to and has focused slavishly on the Draghi put. Proof of this is not only in the single currency move but also in the fact that yields have come tumbling down in the periphery (Spain and Italy 10-year yields by over 250bps) all the while pushing aside the enormous scale of the underlying problems.
Okay, both the eurozone and the U.S. are flooding the financial system with their respective currencies. Is it reckless? Perhaps. But as with the ugly sisters, if both the Fed and the ECB are being reckless with the USD and the EUR, which sister would you rather be dancing with?
And the answer has to be the USD where there is at least a modest growth outlook. Unemployment has some downward momentum, however, small. There is no chance of political disintegration. The Republicans and Democrats may engage in brinkmanship time and time again, whilst kicking the can down the highway, but there are indications (Simpson-Bowles) that politicians on both sides grasp the scale of the problem.
But that's not the same as the situation in the EU, where growth overall is expected to be barely positive in 2013, youth unemployment in the periphery is running at over 50%, overall unemployment in Spain at 25%, the "sustainable" solution to Greek debt has left it forecast to rise to almost 190% in 2013. Political uncertainty will continue with important elections in Italy and Germany. Need I go on? (I could).
Yes, the market has been treating the euro as a proxy risk currency - only if the world looks like it's about to tumble again into financial Armageddon, the USD rallies. Anything better than that scenario and the euro rallies. Which is what has happened over the last six months as the prospect of financial Armageddon has subsided. But as the world gets used to the fact that we're not tumbling into a financial abyss (low growth, yes; abyss, no) the FX markets will at some time change their theme and trade on fundamentals again.
We can argue about the exact figure, but the euro is overvalued by about 15% against the USD, which puts fair value at around the 1.20 mark. Of course, it's well known that currencies can trade away from the fair value for many years at a time. But the disparity between economic progress in the U.S. and in the eurozone means it's not difficult to see the euro selling off in 2013 against the USD back towards the lows of 2012, or at least to the levels it stood at before Draghi stepped in and gave the single currency its boost.
