Deutsche Bank defends the euro

Could the bears be overzealous about the value of the euro? Consider the argument for why it should bounce back towards the end of the year.
Bilal Hafeez
Bilal Hafeez

Sentiment towards the euro has turned extremely bearish given investors' negative outlook on the eurozone's more peripheral economies. Calls for the euro to reach parity with the US dollar are being reflected by record outflows from Europe's single currency. In an interview with FinanceAsia, Bilal Hafeez, Deutsche Bank's global head of FX Strategy, outlines why he thinks the bear case is overdone and says he expects the euro to rally back in the second half of the year.

With the EUR/USD having briefly traded below 1.20, some investors have positioned themselves for the euro reaching parity with the US dollar. Why do you think otherwise?
In short, we think the euro will bounce back because of the relatively weak fiscal position of the United States, which has a fiscal balance that is not much better than Spain's and far worse than the euro area's. The US current account deficit continues to grow -- we estimate it will reach 3.5% by the end of 2010 and almost 4% by 2012. In contrast, Europe has a balanced current account, with a lower aggregate fiscal deficit than the US, UK and Japan.

It's also worth remembering that the €750 billion emergency facility announced on May 10 reduces the probability of a European sovereign defaulting in the next three years, while introducing a mechanism to share fiscal risk across the euro-area. Alongside this, the critical policy response from the European Central Bank (ECB) was to start buying sovereign European bonds. So far, only  €35 billion has been bought -- were the ECB to match the efforts of the US Federal Reserve and Bank of England, it would equate to €1.2 trillion of purchases. This would be enough to buy all the outstanding government debt of Spain, Greece, Portugal and Ireland.

Despite this, the market is still struggling to find any scenario where the euro could stabilise. The most commonly quoted (views) are: to ease the interbank market, the ECB may print money and thereby weaken the euro; strong European growth data could be derailed by fiscal austerity measures; or an easing of concerns over Spain's banking sector may only lead to the next potential problem country appearing.

We think such one-sided thinking bears some resemblance to previous market moves, such as last year's US dollar weakness, where an end was called to its currency reserve status; or asset declines in the wake of Lehman's collapse, which many saw as the beginning of a depression.

We see  EUR/USD recovering to 1.35 by the first quarter of 2011, following a potentially choppy summer.

Markets have begun to turn their eye to Spain as the next potential stress point for the euro area. Just how big an issue is this for the euro?
We believe Spain is on a sustainable fiscal path and that there are adequate backstops to prevent a seizure of the country's banking system. The question therefore is: what can be done to arrest the negative cycle that is currently underway?

Time could be one factor. It took several months after the US Federal Reserve started buying mortgage-backed securities in late 2008 for markets to stabilise. Another could be getting through June and July, which are the largest redemption months for Spanish banks and the government.

Should either of these factors prove troublesome, the ECB is still able to employ a quantitative easing programme, which we expect would be positive for the euro given interest rates are already expected to remain low for some time, while the subsequent reduction in risk premia will likely have a positive impact on the currency. This proved to be case with the British pound in the days following the Bank of England introducing its quantitative easing programme.

In some ways, the parallel with concerns about European sovereign debt and Lehman's collapse is worth noting, given the steady stream of policy measures that were announced without any discernible improvement in market sentiment. While not discounting the understandable fear that the banking system may have collapsed in the case of Lehman, linking current sovereign credit concerns with a break-up in the euro-area is unfounded in our view.

So you don't think the market should be pricing in an end to the euro?
The speed at which credit markets have widened and the euro fallen have led some to fear the break-up of the euro in one way or another. It's true that the financial institutions of the four largest economies in the euro-area have close to €5 trillion of exposure to the sovereign debt of other euro-area countries. However, a break-up to the euro-area would bring into question exactly what that exposure was worth, given an uncertain currency denomination of those claims and liabilities.

There's a big difference between wanting to keep a system intact and being able to. It's worth noting that during this time of stress, Europe's response has been greater integration, rather than disintegration. And the ECB's purchases of sovereign bonds, along with the €750 billion emergency facility announced in May, goes a long way to tackling short-term systemic risk.

In the long-run, a fiscal union could solve many of the structural problems being faced by the euro area. As Europe comes closer to tackle this crisis, we may be moving closer to such an eventuality.

So what does the euro have in store for the summer?
We expect the euro will continue to be fairly volatile over the summer months. Notably, Belgian and Italian bond spreads have begun to widen, no doubt due to their debt-to-GDP ratios of more than100%. If the current level of stress entering European sovereign credit markets were to persist beyond July, then the potential for systemic risk could elicit a stronger response from the ECB in terms of its support for Euro-area government bond yields.

We think it could be possible for EUR/USD to reach 1.15 at some stage over the next three months, which would bring the euro to fair value on a purchasing power parity basis.

The euro seems to have become a barometer for risk appetite. What impact has this sentiment had on the behaviour of investors and institutions?
Positioning has very much benefited the US dollar, given the demand driven by European banks' dollar shortage and a record flight away from other sovereign debt markets and into US Treasuries. These structural outflows from euro-area bond markets and into US markets may persist, but there are and will continue to be reductions of US assets held by European banks, which will curtail future supply issues and perhaps even demand by European investors for US assets -- particularly as sentiment improves.

Indeed, the scale of inflows into US Treasuries suggests that continued risk aversion will be needed to maintain them. We think the market is not properly considering the possibility of euro-area repatriation from US dollars back into euro-area assets, and estimate these flows could be sizeable should sentiment improve more rapidly.

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