EUR – Running on Empty?

The trade-weighted EUR has risen to its strongest levels since the late 1970s, almost 40% above the trough reached in mid-2000. However, the underlying fundamentals are bringing into question of whether EUR may be overvalued.

While German economy remains relatively solid, trade deterioration in the remainder of the Euro zone is becoming more obvious. Weakness in the Irish and Spanish real estate markets has translated a two-tier Euro-zone economy, with the weaker sectors gaining momentum relative to the stronger. From exports, it spreads into domestic production with the German ISM holding above 50 while similar index readings hold below 50 for France, Ireland, Spain and Italy.

And that effectively will put the recent surge in the trade-weighted EUR to be increasingly at risk.

The EU Business Climate Index (BCI) peaked in April 2007 and has fallen steadily over the last year. With an average lead time of about 6 months to changes in the trade-weighted EUR, this suggests that the cyclical support for EUR is waning. With the residual tightening by the ECB to address inflation overshoot, which could be the near-term support for the EUR leads us to believe that EUR trade weighted index gains are increasingly at risk.

As at now, just as the USD was supported by high US rates in the first half of the 1980s, the EUR is supported by higher ECB rates and relatively weaker US fundamentals. The breakout to 1.6018 on April 22 was triggered by two aggressive US rate cuts totaling 125bps in January and that bought the Fed fund rate to below European counterpart for the first time since October 2004.

In the latest Merrill Lynch Fund Manager survey released on June 18, a net 71% of asset allocators believed that the EUR was overvalued, which was a key motivation for them to shift away from European equities.

In short term, it is very difficult to convince the market to dump the EUR today because the ECB’s refi rate is currently twice as high as the Fed fund rate with the ECB still considered to be relatively more hawkish than the Fed.

Beyond that we expect a gradual EUR weakening in 2009 with a move toward 1.45-1.50, resulting more from potential EUR weakening, albeit from very strong levels than USD strength. As the US economy and Fed policy normalization gain momentum in the later part of 2009, it will likely to push the EUR below 1.38 into early 2010.