The False Stability of the Euro
EURUSD broke through the 1.30 level last week, in the aftermath of the elections in France and Greece which cast further doubt upon the ability of European governments to bring excessive public debt levels under control. The euro fared little better against the pound, testing the limits of the 1.22 - 1.25 range which we have been highlighting for a number of weeks. While this EUR weakness is not surprising given the unique problems facing the single currency (while both the US and the UK face similar debt problems to the euro zone, the euro zone has been forced to address these problems within the self-restricting framework of an imbalanced currency union), the slow-motion nature of the euro's decline remains remarkable.
This 'stickiness' is the result of three key influences, each of which serves to delay, or in some instances (temporarily) reverse the gradual decline of the single currency:
1. The desire of both China and the US (and other central banks / sovereigns) to maintain the value of the euro;
2. The reduced impact of speculators, traditionally relied upon to ensure efficient price discovery in the FX market (by ensuring that currencies trade at a level approximating fair value; think of George Soros 'breaking' the Bank of England); and
3. Technical factors resulting in real currency flow that supports the euro (there are two main sources of this flow: 1) deleveraging activity by European banks; and 2) overseas investors looking to capitalize on value opportunities resulting from relative weakness in European financial markets (see chart 2)).
EURO Stoxx 50 (Blue) vs. DJIA (Pink)
As a result of these factors, we continue to witness a gradual erosion in the value of the euro, rather than a complete collapse. Whether this trend continues depends largely on the continued influence of these three factors.
It is unlikely that the US / China will suddenly decide that a drastically weakened euro is in their respective interests. The euro zone, despite its economic problems, remains the largest single market in the world, and neither the US or China can afford to lose competitiveness as a result of a euro devaluation. China has the added incentive of both a sizeable current portfolio of euro assets (mainly government debt) and a desire to ensure that has the continued ability to effectively diversify its $3.2 trillion of FX reserves (USD holdings now only account for about 54% of these reserves, down from 75% in 2006).
The likelihood of speculative investors and traders re-entering the market en masse, and forcing the euro down also seems unlikely for now. Hedge funds are wary of making the same mistake twice (it is difficult enough to have to explain a bad trade to your investors once, let alone twice), and having been burned by the surprising resilience of the euro last year, they will likely remain cautious about jumping on the short euro trade too early.
The third factor, the support being provided to the euro by real money flows is also likely to persist over the short to medium term. A recent IMF study estimated that European banks may have to sell up to $3.8 trillion in assets over the next 18 months (to put this into context, this would be larger than total amount of Chinese FX reserves). Even under their 'base case' scenario the amount of deleveraging would exceed $2.5 trillion. In addition, a lot of the euro selling that is currently taking place (mainly as a result of investors looking to exit the European periphery) is currently being recycled into other European markets (mainly Germany). As a result, the impact the euro itself remains limited.
Despite our expectation that these euro-supportive factors will remain intact, at least for the next six to twelve months, we continue to maintain our EUR-bearish view (1.20 in EURUSD / 1.28 in GBPEUR). However, we do not expect a collapse of the single currency, even in the event of a Greek exit (which is looking increasingly like the most probable outcome; Citibank now place the probability of a Greek exit at 75% in the next 18 months).