The US dollar’s rise

This year’s rise in yields has led to a large valuation reshuffle for many markets. Investors have clearly been obsessed with global bonds, global equities and the US dollar. All assets have endured a negative duration effect (higher yields leading to lower valuations) while the dollar’s rise has been remarkably fast.

The dollar is a systemic risk factor for many markets and the drying-up of dollar liquidity now poses a significant threat to many countries and markets around the globe. Assessing this threat goes far beyond the topic of this week’s article; we are focusing on a specific currency that has been suffering quietly from the dollar’s rise: the euro. Now that a significant part of the Federal Reserve’s (Fed) hikes seems to have been priced in by markets, will we see a stabilisation in the value of the euro?

 

Factors behind the euro’s value

One common mistake made when thinking about the “fair value” of a market is to compare its recent price with where it has been, say, over the past decade. When doing this for the euro versus the US dollar – as shown in figure 1 – the temptation to call a bottom for the euro is strong. Yet, doing so would ignore the fundamental macro factors at work behind the evolution of the currency. There is always room for debate around the selection of these factors, but two appear particularly significant:

• Firstly, the currency of an area where inflation is structurally lower than another should see its currency rise. Why is that? Because if the price of traded goods rises faster in one area, the appeal of buying those goods will decline and so will the demand for the associated currency. Simply put, if I have the opportunity to buy things from an area where prices are growing more  slowly than elsewhere, my spending in that area’s currency will boost the value of its currency to the point where its appeal eventually vanishes – the rising currency will have made the price of goods comparable to my domestic market. This principle is known as “purchasing power parity”.
• The second factor relates to interest rates: economic theory asserts that an area with structurally higher interest rates should have a more expensive currency. Assuming no currency price variation, an area with higher interest rates should attract more capital than an area with lower interest rates. Now in a world of “flexible” currencies, this natural attraction should result in the currency of the area with the highest rates to rise in line with this greater demand. This is the basic force driving “forex carry” strategies, and that theory is known as “interest rate parity”. This force can be attributed to the yen’s lower value, as well as the structural appreciation of the Australian and New Zealand dollars.

Based on these two elements, a currency zone with low inflation and higher interest rates should see the value of its currency rise. Figure 1 illustrates how these forces could be reflected in the price of the euro when rates are higher in the US but inflation is higher in the Eurozone, and suggests that fair value for the euro should be around 1.18. With the EUR/USD currently at parity the euro is very near its trough and should be a screaming buy…

 

Figure 1: EUR/USD vs. fundamental valuations calculated by purchasing power parity (PPP), interest rate parity (IRP) and relative equity performance.

Source: Bloomberg, LOIM

 

Asset attractiveness

A quick sanity check highlights that this scenario is missing at least one explanatory factor, which in this case could well be the relative behaviour of US equities.

One way to assess whether we are missing something is to check whether the spread between the current euro value and its fair value has mean reverted enough. To do that, we used a straight stationarity test and, based only on these factors, the model we created rejected stationarity and, therefore, mean-reversion. In other words, it tells us that purchasing power and interest rate parities are not enough to estimate the fair value of the euro from 1990-2022.

So, what other factors could be added to improve our model? There are a variety of relevant theories, from the twin deficits (trade and fiscal deficits) to the US position in terms of Net Foreign Assets. All of these have been at the centre of academic debates over the past 40 years and still remain largely unresolved. In a recent paper, Atkeson et al. (2022)¹ added a further element to this dispute that we think is particularly relevant to explaining the euro’s valuation variation today: the attractiveness of US assets (or their relative performance) and notably their attractiveness versus the rest of the world. When US assets show stronger prospects (unhedged) than that of the rest of the world, a currency demand grows that makes the dollar stronger and the euro cheaper. In our view, adding that factor to the fundamental valuation of the euro, as shown in figure 1, solves a major part of this puzzle and makes our model’s error mean revert enough.

This improved model yields two main conclusions: firstly, given the attractiveness of US assets in recent years, the euro’s fair value is probably much lower than 1.18 and more likely to be around parity (ouch!). Secondly, a major part of the attractiveness of US equities stems from their former environment of very low rates. With rates rising everywhere, particularly in the US, the growth / value rotation could withdraw a key natural support for the US currency to the benefit of more “value- oriented” European assets. With that in mind, figure 2 highlights that the euro’s fair value could be 1.10, making its current value probably about 10% away from its floor.

 

Figure 2: Fair value scenarios for the EUR vs USD

Source: Bloomberg, LOIM

Simply put, the euro’s value is currently low but it may not have reached its trough. The good news is that this trough should not be much lower if interest rates continue to normalise.

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Macro/Nowcasting Corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. Along with it, we wrap up the macro news of the week.

Our nowcasting indicators currently point to:
•    Worldwide growth is clearly declining. The US and Eurozone are showing signs of decelerating growth momentum while the most recent data shows that this deterioration still has room to go. The US is increasingly showing indications that it is entering into a recession. 
•    Inflation surprises will remain positive for the Eurozone but are declining elsewhere and are now non-existent in the US. 
•    Monetary policy is set to remain on the hawkish side: central bankers are likely to be more hawkish than expected. 

World Growth Nowcaster: Long-Term (left) and Recent Evolution (right)

 

World Inflation Nowcaster: Long-Term (left) and Recent Evolution (right)

 

World Monetary Policy Nowcaster: Long-Term (left) and Recent Evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).