EUR Is Dangerously Well-Priced

Includes: ERO, EU, FXE
by: Evariste Lefeuvre

With Eurogroup Chairman Jean-Claude Juncker's comments that the euro was "dangerously high," I updated a few charts and reiterate my view that the EUR is high because it is in short supply. If the EUR is "too high," it is simply because gross domestic demand is dangerously low!

Risk Aversion: As is well known, the EUR/USD is driven by risk aversion and is highly correlated to risky asset (stocks in particular). The chart below shows that there is a short-run disconnect between the EUR/USD and the S&P 500, but that the medium run link remains unscathed.

Growth differential: As can be seen below, the current reading is slightly ahead of what the PMI spread suggests. But the growth-implied EUR/USD is not far from the current reading. You may be skeptical on the ability of the eurozone to rebound as early as H2 2013, but the abysmal PMI readings may have some room to improve.

Institutional risk: The most appealing relationship in H2 2012 was the strong correlation between the Bono/Bund spread and the EUR/USD. This is clearly linked the ECB announcing the OMT program. As is the case with many EUR drivers since 2008, this might just be another temporary scapegoat that drives the pair. If it were to hold, the next direction is unclear: will Spain ask for help? What would the OMT activation imply for Bono yields? I don't know, but the current reading of the Bono-Bund spread suggests that the EUR/USD is well-priced.

Central Banks' balance sheets: If the EUR is too high, then the ECB should do something (expand its balance sheet). The current reading shows that the pair is already ahead of what the FED/ECB balance sheet ratio suggests. As QE3 is relatively limitless, the ECB will not expand the balance sheet even if OMT is activated (sterilization). Hence, even if the current reading suggests that the EUR/USD is not too high yet, it might increase further if non-conventional monetary policy remains aggressive in the U.S.

Current accounts: The exchange rate of a country that runs a current account surplus tends to appreciate unless there is a regular string of capital outflows. In spite of the dire sovereign crises, net outflows from the eurozone have not been compelling. This explains why there is a medium-run link between the EUR/USD and the current account balance of the area as can be seen below. Periods when the current account improves are generally associated with a strengthening of the external value of the EUR.

This is probably what makes the euro a "strong currency." We cannot rule out that the ECB has gained credibility over time with its neo-conservatism (dual mandate, applied with caution), but most of the strength should be attributable to the structurally positive external accounts.

Juncker's statement suggests that the EUR/USD should be weakened. The implicit message is that the ECB should do it. Yet, the eurozone imports of commodities is quite high, which limits the net impact of a depreciation on GDP growth. In addition, higher import prices when wages are already facing a huge downward pressure would negatively impact the current recession. Lastly, for a EUR depreciation to help, European countries should be able to export more. Unfortunately, as a share of GDP, the export base of many ailing European countries is small, which would limit the "demand switch" (from domestic demand to exports) required for a depreciation to spur exports (and GDP growth).

The chart below provides a good example, showing that the export intensity (defined as the share of exports in total sales for firms reporting positive value in exports) is very low in France, which significantly reduces the positive odds for a weaker currency.

The problem for the eurozone is the message sent by the resilience of the external accounts. It shows a resilience of German exports combined with plummeting imports of ailing countries. But that's not all: it also shows that in spite of a fall in the national growth saving of the area, the investment rate is collapsing even further, which is a very bad omen for potential future growth.

The problem is not that the euro is "dangerously high," but the reason that it remains resilient. This post shows that the problem for the eurozone is the lack of domestic demand that leads to balanced (even positive) external accounts and, therefore, a strong euro.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.