FX MARKET INSIGHTS JUNE 28, 2010 Bloomberg A REVIEW OF GLOBAL MACRO THEMES & CURRENCY INVESTMENT STRATEGIES MICHAEL R. ROSENBERG The Euro’s Long-Term Cycles Volume 5 No.2 Available on the Bloomberg at FXIP <go> <51> or FXMI <go> 8‐Year Downtrend ?‐Year Downtrend 7‐Year Uptrend 8‐Year Uptrend 5‐Year Downtrend
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FX Market InsightsJune 28, 2010
1
Bloomberg
FX MARKET INSIGHTSJUNE 28, 2010
Bloomberg
A REVIEW OF GLOBAL MACRO THEMES &CURRENCY INVESTMENT STRATEGIES
MICHAEL R. ROSENBERG
The Euro’s Long-Term Cycles
Volume 5 No.2 Available on the Bloomberg at FXIP <go> <51> or FXMI <go>
Dollar Bloc ...................................................................................................... 17
Western Europe .............................................................................................. 21
China .............................................................................................................. 25
FX Market InsightsJune 28, 2010
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Bloomberg
Overview
Historically, the euro-dollar exchange rate has tended tomove within long-term cycles of appreciation or deprecia-tion, and has exhibited a tendency to overshoot its pur-chasing power parity (PPP) value by rather large amountsat the cyclical peaks and troughs. In a typical long-termcycle, the euro has risen or fallen for about 5-8 years withPPP overshoots of (plus or minus) 20% before reversingthe trend.
Figure 1 highlights the persistent nature of these long-term upswings and downswings. As shown (using a syn-thetic euro derived from the European legacy currenciesprior to 1999), the euro slid sharply between 1980 and1985, then rose sharply until the ERM crisis in the fall of1992. The euro then embarked on an eight-year downtrend,reaching a cyclical trough of 0.83 in the fall of 2000. Theeuro then trended higher over the next eight years, peak-ing at a record high of 1.60 in July 2008.
The euro is now two years into what might be anotherlong-term downtrend. If the historical pattern of long-termswings were to continue, we might see the euro grippedin a major bear-market cycle for the next 3-5 years; onethat could conceivably take the euro into deeply under-valued territory versus the dollar.
Is the Euro Embarking on a New Long-Term Cycle of Currency Weakness?
As shown in Figure 2, one of the defining characteristicsof the euro's long-term cycles has been the tendency forthe euro's value to overshoot its PPP value by rather largeamounts at both the cyclical peaks and troughs. For ex-ample, the euro overshot to the downside versus the dol-lar in 1985, with the level of PPP undervaluation exceed-ing 50%. The euro's rise versus the dollar over the nextseven-plus years drove the euro into overvalued territoryto the tune of 25%. The euro's subsequent eight-yeardecline versus the dollar resulted in a 30% undershoot ofits PPP value at its cyclical trough in 2000. The euro'sadvance over the 2000-08 period pushed the euro intoovervalued territory to the tune of 30% at the cyclicalpeak in July 2008.
Since then, the euro has erased nearly two-thirds of itspeak level of overvaluation, and if the euro conforms tothe historical pattern of moving in long-term swings, theeuro's current PPP overvaluation should be completelyerased in the coming year. Taking this one step further,one would then expect to see the euro eventually fallinginto undervalued territory, perhaps in the second half of2011 or 2012.
Figure 1Long-Term Cycles in the Euro-Dollar Exchange Rate
(1975-2010)
Source: Bloomberg
Figure 2Euro PPP Over/Undervaluation
(1975-2010)
Source: Bloomberg
8‐YearDowntrend
?‐YearDowntrend
7‐YearUptrend
8‐YearUptrend
5‐YearDowntrend
1985 50% Euro
Undervaluation
200030% Euro
Undervaluation
2008 30% EuroOvervaluation
1992 25% EuroOvervaluation
Possible Long‐Term
Path
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Relatively tight fiscal policies in the Euro-area in the 1990salso exerted downward pressure on the euro during thatperiod (see Figure 6). European governments attemptedto rein in budgetary imbalances in order to satisfyMaastricht Treaty criteria in the run-up to monetary union(EMU), and in response, central banks in the Euro-areafelt compelled to pursue aggressively accommodativemonetary policies to offset the negative effects of fiscalconsolidation.
Although the fundamental forces driving the euro in eachof its major upswings or downswings have differed, it hasbeen the thrust of the policy response to those funda-mentals that has determined the euro’s direction in eachof those cycles. During the euro's slide over the 1992-2000 period, structural rigidities in the Euro-area's laborand product markets contributed to significantly weakerGDP growth in the Euro-area relative to the U.S. (seeFigure 3). Indeed, U.S. productivity growth soared rela-tive to that of the Euro-area beginning in the mid-1990s(see Figure 4) and that was one of the principal drivingforces pushing the euro lower during that period (see Fig-ure 5).
Figure 3
Source: OECD Economic Outlook
U.S. and German Real GDP Growth(1996-2000)
Real GDP Growth (%)
0.98
0.99
1.00
1.01
1.02
1.03
1.04
1.05
1987 1989 1991 1993 1995 1997 1999 20010.80
0.90
1.00
1.10
1.20
1.30
1.40
Euro/US Productivity Ratio US$/Euro
U.S. Tech Boom
Figure 4
Source: OECD Economic Outlook
Figure 5
Source: Bloomberg
Figure 6
Source: Bloomberg
Euro-Area/U.S. Productivity Ratio and the Euro(1987-2001)
Euro-Area/U.S. Productivity Ratio US$/Euro Exchange Rate
Euro-Area Budget Deficit and the Euro(1992-2003)
Euro-Area Budget Deficit (% of GDP) US$/Euro Exchange Rate
U.S. and Euro-Area Productivity Growth(1991-2001)
Productivity Growth Index (1991=100)
0
1
2
3
4
5
6
7
8
1992 1994 1996 1998 2000 20020.80
0.90
1.00
1.10
1.20
1.30
1.40
1.50
1.60
Euro-Area Deficit US$/Euro
Pre-EMU Fiscal Consolidation
-2
-1
0
1
2
3
4
5
6
1993 1994 1995 1996 1997 1998 1999 2000
U.S. Germany
100
105
110
115
120
125
1991 1993 1995 1997 1999 2001
U.S. Euro-Area
U.S. Tech Boom
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As a result, real short-term interest rates in the Euro-area drifted lower over much of the 1990s, which contrib-uted to the long-term decline in the euro's value (see Fig-ure 7). Thus, Europe's overall fiscal/monetary policy mixacted as a drag on the euro's value (see Figure 8).
A strong case can be made that history might be repeat-ing itself in the present period. Euro-area growth is onceagain lagging significantly behind the U.S., fiscal posi-tions in the Euro-area are being tightened (particularlyamong the Euro-area periphery), and the ECB is pursu-ing an aggressively easy monetary policy stance, hopingto prevent Euro-area growth from slipping into negativeterritory. Just like in 1992-2000, this lethal (for a currency)policy mix is once again exerting downward pressure onthe euro's value.
Part of the euro's problems today can be traced to theoutsized gains that it enjoyed versus the dollar over the2000-08 period. The euro-dollar exchange rate rose froma low of 0.83 in October 2000 to a high of 1.60 in April2008, which represented a 30% overvaluation versus thedollar at the euro’s peak. Such an extreme reading madethe euro ripe for a corrective downside move.
For the most part, the rise in the euro-dollar exchange-rate during the 2000-08 period was more a dollar than aeuro phenomenon, as several U.S.-centric forces were atwork driving the dollar lower. For example, the U.S. cur-rent-account deficit widened to a record high of 6.1% (seeFigure 9). Given that current-account imbalances of thatmagnitude are widely considered to be unsustainable,the market responded by driving the dollar sharply lowerto help correct the U.S. current-account shortfall.
0
2
4
6
1992 1993 1994 1995 1996 1997 1998 1999 20000.80
0.90
1.00
1.10
1.20
1.30
1.40
1.50
1.60
Euro Real 3-Mo. Rate US$/Euro
Figure 7
Source: Bloomberg
Euro-Area Real Short-Term Interest Rates and the Euro(1992-2000)
Euro-Area Real 3-Mo. Rate(%) US$/Euro Exchange Rate
Figure 8
Source: Bloomberg
Euro-Area 1992-2000 Monetary/Fiscal Policy Mixand Its Effect on the Euro
AmbiguousEuro
Appreciates
EuroDepreciates
Ambiguous
ExpansionaryMonetary Policy
ExpansionaryFiscal Policy
RestrictiveFiscal Policy
RestrictiveMonetary Policy
2000‐08 Deterioration in U.S. Current Account Balance
Figure 9
Source: Bloomberg
U.S. Current Account as a Percent of GDP(1970-2010)
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Taylor Rule Estimates of the Fed Funds Rate(1990-2010)
In addition, the U.S. experienced persistently low or nega-tive real short-term interest rates—which are generallynegative for a currency—over much of the 2000-08 period(see Figure 10) as Federal Reserve policy was extremelyaccommodative. Indeed, for much of the 2000-08 period,the Fed Funds rate setting was significantly below itsprescribed Taylor Rule level (see Figure 11).
Furthermore, the U.S. was at the epicenter of the 2007-09 Global Financial Crisis and the dollar was heavily soldas a result, particularly in the early stages of the crisis.With the dollar heavily oversold in the summer of 2008,the euro found itself in the precarious position of being30% overvalued versus the dollar.
The corrective move in the euro-dollar exchange rate sinceits July 2008 peak has already erased roughly two-thirdsof the euro's peak PPP overvaluation. We estimate thatthe euro is still overvalued by around 9%-10% versus thedollar and we think a strong case can be made for afurther corrective slide in the euro's value, not just to oureuro-dollar PPP estimate of 1.12, but to perhaps 10%-20% below fair value. We base this on several criteria.
First, Euro-area GDP growth is once again lagging con-siderably behind the U.S. and is expected to remain sowell into the future. As Figure 12 shows, the Euro-areaeconomy contracted more than the U.S. in 2009, despitethe central role of the U.S. in the financial crisis. Further-more, the U.S. is recovering at a faster pace than theEuro-area in 2010 and consensus forecasts are callingfor a continuation of that pattern into 2011.
-8
-6
-4
-2
0
2
4
6
8
1980 1985 1990 1995 2000 2005 2010
Persistently Low or Negative Real Three‐Month T‐Bill Rates
$55‐$60 BillionDeficits
U.S. Real Short-Term Interest Rates(1980-2010)
Three-Month T-Bill Rate less CPI (%)
Figure 10
Source: Bloomberg
Figure 11
-5
-4
-3
-2
-1
0
1
2
3
4
2006 2007 2008 2009 2010p 2011pU.S. Euro-Area
Figure 12
Source: OECD Economic Outlook
U.S. and Euro-Area Real GDP Growth(2006-2009 and OECD Forecasts for 2010-11)
Real GDP Growth (%)
Source: Bloomberg
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Figure 13
Source: Bloomberg
ECRI Leading Economic Indicator for the U.S.(1990-2010)
Figure 15
Source: Bloomberg
OECD Leading Economic Indicator for China(1990-2010)
Figure 14
Source: Bloomberg
Second, a weaker euro could help sustain Euro-areagrowth in an environment of moderating global growth.There are signs that world growth might be at risk of de-celerating in the near future and that could undermineEuropean exports, which have been the principal driver ofEuro-area growth. Indeed, the OECD's leading economicindicators for China and Brazil suggest that their growthcycles might be peaking (see Figures 13-14), and therecent slippage in the Economic Cycle ResearchInstitute's weekly leading economic index suggests thatU.S. growth might slow in the months ahead as well (seeFigure 15).
Third, while it remains the case that on an aggregatebasis the euro is presently overvalued by 9%-10%, a casecould be made that a number of Euro-area members mightbe suffering a greater loss in competitiveness than the9%-10% PPP overvaluation estimate suggests. As Fig-ure 16 shows, based on relative unit labor costs, Greece,Spain, Portugal, and Ireland are considerably less com-petitive than Germany and France.
Fourth, euro weakness might be needed to support growthat a time when Euro-area fiscal consolidation will likelybe restricting growth. Euro-area member countries, par-ticularly in the periphery, are currently under pressure tobring their budgetary balances closer to sustainable lev-els.
Signs of a Slowdown
Signs of a Slowdown
OECD Leading Economic Indicator for Brazil(1990-2010)
Euro-Member Real Effective Exchange Rates(1999=100)
REER Index (1999=100)
Figure 16
80
85
90
95
100
105
110
115
120
Germany France Greece Spain Portugal Ireland
Source: Bloomberg
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Fifth, although long-term interest rates are presently quitelow in Germany, they are actually quite high in the caseof Greece, Ireland, Portugal, and Spain (see Figure 17).Those relatively high yields reflect the credit risk associ-ated with the sovereign debt of the Euro-area periphery.Since high long-term interest rates in those countries willact as a drag on GDP growth, a weaker euro would helpto offset that drag.
Finally, the Euro-area faces significant tail-risk lookingforward. While both ECB and consensus economic fore-casts call for positive Euro-area GDP growth in the fu-ture, the distribution of possible Euro-area economic out-comes has a fat negative tail, reflecting the economicand financial risks facing the global economy, and in par-ticular, the Euro-area recovery.
Mohammed El-Erian of PIMCO likens the situation fac-ing Europe and the global economy as similar to driving acar without a spare tire. Applying this analogy, globalpolicymakers used their spare tire (massive fiscal stimu-lus and near-zero interest rates) in 2008 and 2009 to dealwith the economic and financial crisis during that period.Unfortunately, the road ahead still appears to be rocky,but this time around there’s no spare in the trunk if theworld economy gets another flat!
On the policy front, the Euro-area appears to be operat-ing with far fewer degrees of freedom than the U.S. at thepresent time. GDP growth in the U.S. is running consid-erably faster than the Euro-area, plus the market appearsespecially concerned by the deterioration in the creditquality of peripheral Euro-area sovereign debt instruments.The wide level in credit default swap spreads, despite therecent EU/IMF package, is evidence of such concern (seeFigure 18).
Overall, the current sluggish pace of Euro-area growth,the relatively tight-fiscal/easy-monetary policy mix cur-rently being pursued in Europe, the rising risk premiumassociated with Euro-area assets, and a still overvaluedeuro are eerily reminiscent of the fundamental forces thathelped contribute to a weaker euro over the 1992-2000period. It would thus appear that the ducks are lining upfor a repeat performance that could see the euro declineon a trend basis in the coming years.