As April draws to a close, the euro is coming under renewed pressure from three new fundamental factors. Not only that, but the existing sources of bearish pressure are becoming more pronounced. The combined factors are now sufficiently strong to push the euro through the lower band of its 3-month trading range of 1.30 to 1.34, headed towards a longer-term target of 1.20.
The three new factors are varied and diverse, and will not be easy for the euro to overcome over the weeks and months ahead. Beginning with Monday's European economic releases, we saw that the EC's manufacturing PMI was much weaker than expected, coming at 46 rather than the consensus 48.1. This is an unusually large "miss," and well below the demarcation line of 50 that separates growth from recession.
This unexpected weakness shows a significant weakening of Europe's manufacturing reading compared to that of the US. The red line in the chart above represents the European PMI minus the US PMI. As the line falls, it shows relative European weakness, and is now approaching the low set at the end of last year. This relationship leads the euro by about 5 months based on the pair's optimized correlation, so the red line has been shifted forward 5 months in the chart.
The second factor is the slow dissipation of LTRO funds away from the ECB and back to the banks or their counterparties. LTRO is the acronym given to the ECB's ambitious program to lend funds to at least 800 of the EC's banks to improve liquidity. As detailed in this earlier article, LTRO is similar to the Fed's various QE programs in that proceeds from the lending should find their way into the economy. QE had a significant weakening effect on the dollar, but so far there has been no apparent impact on the euro. In fact, the euro has registered a 1% gain against the dollar since LTRO's inception on December 21 of last year.
However, LTRO is not working in exactly the same way as the Fed's QE programs. In the case of LTRO, banks have been loaned about EUR 500 billion in net new loans, in two tranches. So far, most of the loan proceeds have effectively remained at the ECB. The chart above shows overnight bank loan balances at the central bank, and we can see two rapid rises up, one just after the first LTRO tranche on December 21, and the second just after the second tranche on February 28. This effective sterilization explains why the euro has not been affected--the funds borrowed by banks went right back to the ECB. However, now we can see funds being put to use, with balances declining from a high of EUR 816 billion to the most recent reading of EUR 775 billion.
The third factor that can affect the euro occurred over the weekend, with the French election. It seems increasingly likely that challenger Francois Hollande will be the next president of France. (Oddmakers are giving Hollande an 83% chance of victory.) As described here, Hollande's platform is similar to that of Francois Mitterrand, France's president from 1981-1995. Both are from the same political party; both only reluctantly accept European integration; both embrace an agenda of increased social programs and benefits. Even the presentation of the platforms are similar--Mitterrand had his "110 Propositions," while Hollande is campaigning on "60 Engagements," perhaps in an effort to emulate Mitterrand's success.
Mitterrand's first election occurred in May 1981, and as the graph makes clear, the French franc began to weaken, nearly halving in value over the next 3 1/2 years before peaking above 10 per dollar and then reversing. It is of course difficult to compare the current period with that of thirty years ago, but the number of similarities is striking, and there is no mistaking the direction of the currency during Mitterrand's first years in office.
These three new factors are set to weigh on the euro over the next few months, if not longer, and we can also expect a renewed impact from factors already at play. To begin with, the euro is still very overvalued in terms of its purchasing power parity, from 5-15% too expensive, depending on the method of calculation. By one popular method, the Big Mac Index, the euro is 12% overvalued. This tells us that all things being equal, the euro should tend to cheapen towards purchasing power parity equilibrium.
One reason why currencies become overvalued (and often stay that way) is the difference in interest rates between the two countries. In the case of the euro, 5-year interest rates on the continent are about 0.17% lower than 5-year US treasuries--down from the high of about 0.30% earlier this month, but still nicely positive, and supportive of the dollar. Based on interest rates, there is no reason to buy the euro.
Another element weighing against the euro is the makeup of the currency. The euro is the sum of the exchange rates of the 17 countries that make up the Eurozone. The remarkable commitment that member states have demonstrated in keeping the Eurozone intact actually works to cheapen the euro. If the weaker countries such as Greece and Portugal were to leave, the stronger states such as Germany and France would represent a larger piece of the euro pie, leading to an appreciation of the currency. The fact that the distressed countries remain and will continue to remain in the foreseeable future, can only serve to devalue the currency.
Some market observers have argued that it is because of Europe's problems, not in spite of them, that the euro is strong. The thinking goes that euros have been destroyed by asset price declines, translating to less euros through wealth destruction and therefore less supply, leading to a more expensive currency. Although the logic of the argument is plausible, we did not see this effect in the United States during the financial crisis. In fact, the value of the dollar has been rangebound and is virtually the same price today as it was at the end of 2007, when the Great Recession began.
The euro has been in a rather tight band for several months now, biding time until market forces work to push it in one direction or the other. As events in Europe unfold, more and more factors that will cheapen the currency are coming into play. Apart from the very early part of the year when the euro tested the 1.27 level, the euro has remained in a tight range. But forces are now in place that should lead to a test and possible break of the currency's lower bands. The euro is very expensive, and a new equilibrium is overdue.
Disclosure: I am short euro currency futures.