The Euro and pound are gaining strength against the dollar as a result of strong economic data out of Europe and lower than expected inflation in the United States. However, these factors are not enough to justify the euro's strength over the long term, and I believe the trend will reverse in favor of the dollar over the next 12 months as more economic data becomes available.
The Euro Becomes Overvalued
Many observers have been disappointed by the U.S inflation data from May and June, which both came in below 2%. The weak inflation has put the Fed's rate hike plans in doubt. And this, coupled with Donald Trump's bearish rhetoric on the dollar, has served to push down the dollar against major currency pairs, specifically the pound and the Euro. Over the last six months, the Currencyshares Japanese Yen ETF (NYSE:FXY) has gone up 1.55%, the Currencyshares British Pound ETF (FXB) has gone up 4.27% and the Currencyshares Euro ETF (FXE) has gone up a staggering 8.80%. The dollar index is in the low 90s.
The bullish movement in the Euro could possibly result from a belief that the European Central Bank, ECB, will tighten its monetary policy while the U.S Federal Reserve becomes more dovish. But I believe this thesis is ignoring some of the major fundamental problems with the European economy.
The economic performance in Europe is geographically mixed and this makes it difficult for the ECB to tighten its policy without hurting economies that aren't ready for tightening. Spain's unemployment rate is still over 17% while the total unemployment rate is 9.1% for the economic zone. There is large labor market slack, and this drags down wage growth and inflation. The ECB is unlikely to take a hawkish course when many parts of the European economy are clearly still unhealthy.
The dollar is being unreasonably suppressed by speculation on U.S politics - although to be fair these factors may have unreasonably boosted it in the past. The markets are taking Trump's "weak dollar" rhetoric too seriously while completely disregarding his rhetoric on taxes and fiscal spending. While there are reasonable doubts about the likelihood of the U.S president's ability to enact his policy, it is unreasonable for the market to trade on bearish information while ignoring potentially bullish information.
The euro has gone up unreasonably high against the dollar even though the European economy is clearly not ready for a hawkish ECB due to high unemployment and labor market slack. The strength of the euro is partially due to funds flowing out of the dollar and into the euro based on an unreasonably pessimistic market forecast of U.S inflation. The U.S Fed has plenty of time to wait for inflation in 2017. And I believe it is more likely that we will see U.S inflation pick up before we see a hawkish ECB.
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