Euro, Euro Everywhere
The Euro is certainly beginning 2007 on a strong note and the blogosphere also features musings about whether the Euro is about to take over the clout of the Greenback. The Economonitor (Felix Salmon) reports on a piece from the FT about how the Euro is about to surpass the Dollar measured on the basic monetary indicator M0 which measures physical notes in circulation and not the money supply which multiplies the monetary stock (M0) with a factor (the money multiplier) to make it the M3 or M4. Meanwhile, New Economist asks generally whether it is finally curtains for the Greenback citing among other things the small yet important recent diversification moves made by foreign CBs from Dollars into Euros. However, until Brad Setser tells me otherwise I don't think the fundamentals have changed much here. New Economist also does admittedly make the subtle yet crucial point in my opinion that the Yuan rather than the Euro will take over from the Dollar at some point in the future. The Yuan is not that important here in my opinion but the Euro is and any talk about the Euro as a reserve currency needs to take the big picture and essentially long term, as such we need to consider some of the big emerging economies here ... India anyone? Lastly, the Economist's econblog Free Exchange also picks up on the discussion and quite simply asks whether the Dollar is in fact dead?
So what is this fuzz all about? First of all, this seems to be an all time favourite end of the year topic and consequently we also had a similar discussion going out of 2005. Back then, it was specifically noted how the Dollar stayed strong in 2005 mainly because the Fed kept rates higher than in the Eurozone and in Japan who at that time was still running its ZIRP (zero-interest-rate-policy). This is an important point because it tells us a lot about what is currently happening in the big currency markets. Interest differentials matter here and the developments in 2006 also show us this. To that end let us rewind back to the spring of 2006 when Japan ended its ZIRP and excess liquidity and inflation was the important topics. On the back of two very strong quarters in 2006 it was a widely cited analysis that now the time had come for the major central banks to embark on a joint hike to scoop up excess global liquidity, after all: Growth was indeed strong. However, as we have moved along things have not been as we expected. Most notably, the BOJ in Japan has not been able to exceed the token raise to 0.25% which itself was what took Japan out of ZIRP. In the US the Fed also ran into trouble as the housing market suddenly took a dive and as a result the US is going out of 2006 with a significantly lower growth rate which at this point does not permit the Fed to raise. This brings us to Eurozone and here the ECB has stubbornly continued to raise and this is consequently where we stand going out of 2006 where inflation is below target but the monetary supply (M3) is still prompting vigilance alongside what is coined as future inflationary pressures. As a result, I see the recent fall in the Dollar against the Euro as being mainly driven by expectations on interest differentials and not evidence that the Dollar is heading for a short term and sudden crash; see also my analysis here and here.
Interestingly enough, the bullishness on the Euro going into 2007 relative to the Yen and the Dollar also seems to be driven much by the expectations on interest differentials.
The euro had its biggest quarterly advance against the yen since the period ended June 2003 as the European Central Bank raised interest rates more than the Bank of Japan, boosting the allure of European assets.
(...)
The ECB will continue to be more aggressive in raising interest rates than the Fed and the BOJ next year,'' said Samarjit Shankar, director of global strategy for the foreign exchange group in Boston at Mellon Financial Corp. ``Growth outlook in the euro zone is positive. It supports the euro.
This outlook on interest differentials in 2007 is also mirrored in the year end analysis looking into 2007 by Global Insight who sees a Fed loosening down to 4.5% from its current 5% at the same as the ECB will raise two times bringing the ECB rate up to 4%. Predicting year-to-year interest rates is a bit like predicting the weather but in terms of the general dynamics I would like to question the ability of the ECB to raise if the Fed indeed goes down. Also, as I have recently argued I am not very bullish on Japan either. So, am I being too bearish and doom and gloom here? Perhaps I am, but one thing to remember is that for the ECB (and indeed the BOJ) to raise where Fed goes south we are also assuming a process of de-coupling and subsequent gradual re-balancing. Such dynamics might be present in for example the first quarter of 2007 but to argue that it will be a sustained process is not at all clear at this point in my opinion.