Is The EUR/USD Heading Toward 1?

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 |  Includes: FXE, UDN, UUP
by: Matteo Radaelli

Last week's ECB decision to cut the Refi Rate and the deposit by 25bp - respectively to 0.75% and 0% - was not enough to push up the European equity markets as the CB did not give any indication on a further easing of monetary policy in the months ahead. Indeed, during the press conference, ECB President Mario Draghi did not signal that a third LTRO for the commercial banks or a reactivation of the SMP is imminent.

An important consequence of the ECB rate cut was the decline of the Euro versus the whole of major international currencies, and especially the U.S. Dollar: the EUR/USD fell below 1.23 for the first time since June 1st.

In our view the recent downward of the Euro versus the U.S. Dollar may continue in the next few months, especially if the ECB is going to cut the Refi rate again during the summer as expected by some investment banks.

Following last week's rate cut, the Euro become even more a financing currency in the carry trade operations versus the Australian and New Zealand Dollar and the Swedish and the Norwegian Krone. On the other side, the positive interest rate differential versus the U.S. Dollar and Sterling narrowed, lowering the incentive for private investors to hold the Euro.

Lowering the value of the Euro may be the hidden goal of the ECB in the next few months. Indeed a weakening of the Euro may be the most positive news for the eurozone economies now. According to OECD estimates, a 10% Euro decline of the Euro can stimulate economic growth by 0.8% after 1 year and by 0.9% after two years. The 25bp rate cut implemented on Thursday 5th should increase GDP growth by 0.1%.

For this reason, a decline of the EUR/USD toward 1 - the target for the exchange rate set some months ago by John Taylor of Fx Concepts - will be the most positive outcome for the Euro zone.

But is 1 a credible target for the EUR/USD?

At 1, the EUR/USD would be undervalued by 20% according to the OECD Purchasing Power Parity. This will not be an extraordinary event in an historical perspective, as indicated by the following graph.

It shows that movements by +/- 20% vs. the OECD's PPP fair value are not unusual for the exchange rate:

1) In 1995 the Euro (using the Deutsche Mark as benchmark) was undervalued by 30%

2) In 2000/2002 it was undervalued by 20%

3) In 2008 it was overvalued by 20%.

In a medium term perspective there are other factors that point toward a Euro decline. Even not considering the scenario of a Euro zone break up, the weakness of the Euro economy is likely to persist for many years, especially in the peripheral countries. In this scenario the incentive for investors to purchase Euro denominated assets will remain low and capital flow may continue to remain negative.

Moreover, the tightening fiscal policies adopted in the Euro zone are likely to push the currency down. As shown by the following graph, the austerity measures had the effect in the past to weaken the Euro as they weigh on the economic growth and force the ECB to pursue easing monetary policies.

Finally, looking ahead, when the current economic crisis will end the Fed is likely to start raising rates before the ECB and at stronger pace. In this case the interest rate differential will become favorable to the U.S. Dollar, increasing incentives to invest in the U.S. Dollar.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.