The Euro's Going Down. If It Doesn't Go Up.

The euro will be at $ 0.80 by the end of 2017, losing a quarter of its value from current levels and setting new lows, say Goldman Sachs analysts.

No it won’t. The euro will appreciate around 15% to $ 1.20 over the same period, say HSBC’s economists.

These forecasts may be at opposite extremes of the current consensus, which is broadly for more euro weakness from $ 1.06 where it trades now. But they’re both built on solid arguments. Which to believe depends on what your outlook is for how the global economy shapes up.

The Goldman Sachs view is based on expectations that U.S. monetary policy will start to normalize, which is to say the Federal Reserve will at long last raise its key interest rate from the current near-zero levels as the U.S. economy recovers. At the same time that the Fed tightens, the European Central Bank is keeping monetary policy on full throttle. This will cause investors to shift cash from eurozone assets and across the Atlantic.

And though everyone is talking about the strong dollar, the currency is actually “underpositioned,” according to a recent Goldman note, which is to say the money flows haven’t kept pace with the prevalent views.

What’s more, a eurozone recovery won’t initially be good news for the currency, according to the note. Economic strength will see a pickup in domestic demand, which will weaken the region’s current account position and thus tend to push the currency downward.

That doesn’t mean an 80 cent euro is fair value. But history has shown that foreign exchange markets are more volatile than simple models suggest they ought to be. Economists argue that’s because financial markets move faster than the real economy–prices of goods and trade flows–which leads currencies to fall well below their fair value until assets priced in that currency show compelling value.

Indeed, the Goldman analysts estimate the euro’s fair value to be around $ 1.20.

Which, intriguingly, is where the HSBC economists put the euro-dollar exchange rate in around two-and-a-half years’ time.

Their argument is that the dollar’s gains have gone far enough. Excluding monster dollar rallies of the early 1980s and another one in the run up to the end of the millennium, the current surge is substantially bigger than the usual run-of-the-mill dollar surge, having gained a quarter in value since last summer. As a result, HSBC figures the dollar is now one of the world’s most overvalued currencies, second only to the Swiss franc.

The markets have priced in divergent monetary policy paths on the two sides of the Atlantic. The result is that dollar bullishness has become the consensus trade.

But now the strong dollar seems to be taking a bite out of the U.S. economy while the eurozone has been picking up. Whereas U.S. data have consistently surprised on the downside during the past six months or so, Europe’s have surprised on the up.

The Fed has been taking an increasing interest in the dollar’s appreciation. Although the U.S. is a relatively closed econom — so the exchange rate tends to have less impact on domestic fundamentals than it does in, say, the U.K. — the strong dollar has started to eat into the earnings of the U.S.’s multinationals. So far, this hasn’t registered in the jobs numbers. But employment is a lagging indicator and is one of the few points of recent strength in the U.S. economy.

Meanwhile, the rising dollar has put downward pressure on commodity prices, which, in turn, has pushed U.S. inflation down as well. All of which suggests Fed policy will remain accommodative for longer than the consensus expects. And what’s bearish for the dollar will be bullish for the euro. That’s not to say the euro might not weaken further over the near term. But the turning point is near, according to the HSBC analysts.

Who’s right? Foreign exchange markets are notoriously difficult to call. But both euro bulls and bears have strong arguments to fall back on.

Leave a Reply

Your email address will not be published. Required fields are marked *