Finding the answer to the euro/dollar exchange rate equation is like evaluating two sides of the same coin. The question is, which one will land face up, and when? The answer, however, is dividing the brightest and most influential financial minds around the world into two camps with radically different forecasts for the year ahead.
A depreciating greenback?
Aside from being a medium of exchange, the dollar is a safe haven through United States Treasuries, a unit of account for commodities and trades, an anchor for pegging currencies and a carry trade currency. With such numerous functions, the future of the reserve currency is not only important for the US economy; it is also an essential element for both developed and emerging markets.
Today, the US needs to address the low prospects for economic growth, a weak labor market and a depressed housing sector. However, to tackle these three issues, Uncle Sam decided to engage in unprecedented monetary expansion (namely low rates and quantitative easing) as well as fiscal leniency through a tax deal that will widen its current account deficit, thus indirectly depreciating the US dollar.
Additionally, the amount of liquidity injected into markets is partly flowing out of the country into other markets or into dollar-denominated assets such as hard commodities, which is catching the US in a “liquidity trap.” Indeed, such outflow of liquidity undermines what the measure is actually trying to do, to the extent that the beneficiary of the long-awaited growth may even become the Canadian and Mexican economies and their respective currencies, to the detriment of the US dollar.
Lastly, there is an increase in commodity prices and US equity markets predicted for this year, which are, in effect, inversely correlated to the US dollar.
A European domino effect
Europe’s outstanding debt and debt servicing uncertainties are major issues for the monetary union. In 2011, instead of bailing out Greece’s pensions or Ireland’s banking system, the Eurozone might need to rescue Portugal, Spain, Italy or even Belgium. Furthermore, given the large upcoming Spanish and Portuguese maturities in the second quarter, debt rollover risks will not be contained, especially as refinancing gets more expensive.
Moreover, as if debt-related issues were not enough trouble, the Eurozone also faces a two-speed economic recuperation internally, which is challenging from a monetary standpoint because the European Central Bank (ECB) rate, at 1 percent, is too low for countries experiencing solid growth like Germany and too high for Europe’s ‘peripherals’ — Portugal, Ireland, Italy, Greece and Spain — who have acquired the unflattering acronym “PIIGS.”
Today, the Eurozone is stuck in a difficult situation, with limited tools, because the European Central Bank can only tackle its problems using monetary policy since the Eurozone is not fiscally integrated.
Adding to the “known” unknowns described above, additional unpredictable events and tail risks have yet to be priced into the currency equation. Among possible ‘black swans,’ three potential scenarios would undoubtedly weigh negatively on the US dollar.
“For many decades, the US benefited from having the reserve currency and a robust Treasury market, but we need to get our fiscal house in order,” explained Neel Kashkari, Managing Director and Head of New Investment Initiatives at PIMCO, in an interview with Bloomberg. “If we wait until we have an acute fiscal crisis the way it is happening in Europe, it could take years or decades to restore confidence.”
Secondly, as the US struggles to balance short-term priorities with long-term realities, there is also potential for a double-dip recession by 2012, especially given the historical median of expansionary periods, lasting 30 months on average, in the last three decades.
Lastly, given worries about the outlook for the US, and with China holding some $2.85 trillion in reserves, Chinese President Hu Jintao is actively seeking to promote a global yuan and change the current international currency system.
Across the pond, tail risks that would depress the euro include Eurozone sovereign restructuring — a more sophisticated synonym for “default” — which could entail haircuts for bondholders, as well as an unlikely but not impossible euro breakup.
Erratic and choppy fluctuations
“A lot of downside risks were already priced in the euro,” explains Daniel Brehon, foreign exchange (FX) strategist at Deutsche Bank, “whereas none of the upside risks such as the Eurozone finance ministers meeting, a potential issuance of Eurobonds, or mechanisms whereby Germany would step in, were priced in.”
Thus, these internal euro-supportive forces as well as other external forces such as Asian demand for Eurozone debt and investors’ positioning (since the market was widely shorting the euro via ‘stop-losses’) have helped the euro appreciate in January and might contribute to a euro rally until the news is digested.
“However, the situation is not resolved. The meeting of the Eurozone finance ministers lacked progress on expanding the size and scope of the European Financial Stability Facility (EFSF), and thus the elements of pressure in the peripheral debt markets will again intensify,” explains Robert Lynch, head of G10 FX strategy at HSBC. “Hence, we are more comfortable with a euro/dollar at 1.25 for the first quarter than at 1.35.”
As for year-end, there are two distinct schools of thought. The first one argues that effective solutions to the Eurozone crisis along with structural imbalances in the US will strengthen the euro and weaken the US dollar in the long-term. This school forecasts the rate to trade up to 1.50 on the back of growing fears of the American current-account deficit, unresolved unemployment issues and a mortgage funding gap. Moreover, structural outflows to other markets, diversification from the US dollar due to overweight exposure and the questioning of the US dollar’s status as a safe haven currency, would also weigh down on the buck.
The second school of thought emphasizes the potential for greater disappointment on the Eurozone side. “Not only does Europe need to tackle the debt issue, but it also needs to restructure the banks given how undercapitalized they are; they ideally need something such as a European TARP [Troubled Asset Relief Program],” says Gabriel de Kock, head of US FX strategy at Morgan Stanley.
As the debt will then look artificially inflated, a higher risk premium will be attached to it; rates would increase, which will cause the euro to sell off. Moreover, the second school believes that the US dollar will perform well on the back of good figures in the second half of 2011, predicting in some cases that US inflation might peak, which would cause policy tightening and ultimately be US dollar positive. “Although there currently is optimism in the Eurozone market, the euro/dollar will be choppy throughout the year, but a choppy downward trend,” insists Brian Kim, FX strategist at UBS.
So what now?
A popular strategy would be to short euros in the first quarter when the upswing seen at the end of January decelerates, but initiate a long euro/dollar position when it hits the mid-to-low 1.20s, since consensus remains generally higher than 1.25 in the long-term.
However, given the erratic FX outlook, with brokers forecasting the rate trading anywhere between 1.20 and 1.50 at year-end, it might make sense to look at hedging, using options or forwards, in order to manage risk or to bet on volatility trades (volatility arbitrage).
If directional investors think that the current implied volatility of options is lower than their forecast for the future realized volatility, then they should “long” the volatility; in other words, buy an option and delta-hedge it.
Finally, with a choppy rate and expensive standard options strategies, euro-bearish investors might also prefer to look at cheaper options by either selling euro/dollar spot and buying a cheap digital out-of-the-money call option or even venture into more exotic strategies, such as window knock-ins. But directional investors beware: this is just one side of the coin.
NATACHA TANNOUS is EXECUTIVE’S financial correspondent