Just shy of a year ago, the euro started to decline at a stately pace against the U.S. dollar. In mid-December that descent became a rout. Since late February it’s been more like a jump from a plane — without the parachute. By March 13 the European currency had dropped to $1.05 from a May 2014 peak of $1.40.
“The stars have been aligned for a euro-dollar move,” says Grant Peterkin, manager of the Total Return Bond Fund at Sfr49 billion ($49 billion) Lombard Odier Investment Managers in Geneva. He cites strong February figures for U.S. nonfarm employment, continued concerns about Greece and the March 9 launch of quantitative easing by the European Central Bank. The euro could drop to parity within three months, warns Peterkin, who has bought put options to hedge against this. Roger Hallam, CIO of global currencies at J.P. Morgan Asset Management in London, echoes his view, describing the prospect of parity in the next few months as “a very real risk.”
Standard models of currency valuation suggest that a fall in the euro to $1 makes no logical sense. On a purchasing power parity basis, the euro should be between about $1.25 and $1.30, Hallam notes. But “flow dynamics can be very powerful and override any semblance of fair value in the near term,” he says. In Hallam’s opinion two things keep putting downward pressure on the European currency: U.S. investors hedging euro assets and their euro zone–based counterparts responding to extremely low euro debt yields by moving money stateside. The low rates on debt stem from ECB policy, in particular QE.
Gareth Isaac, a London-based fixed-income fund manager with £300 billion ($444 billion) investment firm Schroders, agrees that according to some conventional criteria the euro should be higher against the dollar — or at least not any lower. However, “the problem with looking at currencies with traditional valuation methods is that they don’t really incorporate major central bank actions, including the huge distortionary effect of QE,” Isaac explains.
Many euro watchers think the sheer downward momentum of the currency could carry it even lower in the short term, with investors exiting euro assets or selling their euro exposure forward through derivatives out of a self-fulfilling fear that it will fall yet more. But many of the same people also see a limit to how much further it can drop and an eventual stabilization at close to the current level.
Peterkin of Lombard Odier reckons the ECB would take action to stabilize the euro before it plunged to as low as 90 cents, perhaps by announcing a reduction in its planned €1.1 trillion ($1.17 trillion) worth of bond buying. After all, central bank president Mario Draghi knows the currency doesn’t need to sink that far for him to achieve his goals of boosting exports and keeping deflation at bay. “Draghi must be pretty happy about what’s going on with the euro,” Peterkin says. “From an export focus he has got to be over the moon.” Even without a further fall, “a rate of $1.05 or $1.06 is probably pretty comfortable for him,” he adds. But Draghi has to consider the disquiet from the powerful hawks at Deutsche Bundesbank, Germany’s central bank, should the euro decline much more.
“We’re closer to the bottom than to the top; it’s most of the way through its downward move,” says Schroders’ Isaac, who isn’t expecting a “euro crisis” that sees the currency slide far below what central bankers want. One key factor: Unlike countries such as South Africa and Turkey, whose currencies have spun out of control because of balance-of-payments problems, “the euro zone still has a current-account surplus,” Isaac says.
Still, the likelihood that most of the fall has already happened doesn’t preclude the chance of high volatility. JPMAM’s Hallam says euro-dollar realized volatility fell to as low as 3 to 4 percent last July but has generally been 10 to 12 percent this year, as the currency cross has whipsawed in reaction to uncertainty about central bank policy on both sides of the Atlantic. He expects volatility to be high for currencies as a whole in the coming months because of growing divergence among central banks. The most notable cleavage involves the U.S. Federal Reserve Board, which is poised to raise rates, and the ECB, which has just made monetary policy even looser.
Hallam’s response: “We have been telling U.S. investors that they need to consider their strategic hedge ratios for foreign assets” — including the possibility that they should step up hedging. The more they listen to him and his colleagues, the lower the euro will go against the dollar as U.S. investors sell the euro forward. •
