Is the euro trading like the Deutschmark?

October 22, 2010

The strength of the single currency since August has astounded some commentators in the markets. After reaching a low back in June, the euro has appreciated more than 17 percent against the U.S. dollar and eight percent on a trade-weighted basis.

Not even last month’s debt crisis in Ireland, when the Irish government announced that its total budget deficit would top 30 percent of GDP this year due to the bailout of Anglo Irish Bank, stood in the way of the single currency. The ease with which the euro can brush off concerns about the Eurozone peripherals since the summer has led people to ask if the euro is trading like a proxy for the German economy.

There was confirmation earlier this week that the German economy is firing on all cylinders. PMI surveys, which measure activity in the manufacturing and services sectors of the economy, remain at elevated levels, industrial sector confidence measured by the IFO survey is back at pre-recession highs and the unemployment rate is at its lowest level since 1992. Combined with relatively low levels of public debt – it is currently running a deficit of 3.3 percent – and quarterly growth of 3.7 percent between April and June, Germany’s economy looks more like an emerging market than a western one.

As you can see in the chart below, the euro is riding on the coat tails of a strong Germany. The spread between German and U.S. two-year yields has tracked euro-U.S. dollar extremely closely.

Chart_reuters

But should the euro be a proxy for German economic strength? The euro is a currency union after all, and like any good team surely it should only be as strong as its weakest members, in this case Ireland and Greece. Growth in Ireland and Greece slipped back into negative territory in the second quarter, and the outlook for both economies remains weak as they embark on severe fiscal re-adjustment. If the euro was reflective of these economies, then it should be back around the lows of 1.18 against the dollar, some may even argue it should be below parity.

On the other hand, the euro should act like the Deutschmark as Germany is the largest and most important economy in the Eurozone. A stronger euro is therefore justified because strong growth and a tight labour market are pushing up German bond yields, putting upward pressure on the single currency.

But could the euro be at risk if the market re-focuses its attentions on the weaker Eurozone economies and not only Germany? Yes. The two-speed European economy will prove a massive headache for the ECB when it goes to set policy. Germany may not have an inflation problem at the moment, CPI is currently 1.3 percent, but the ingredients are all there – strong growth and a tight labour market – to fan the flames of price increases. This compares with the peripheral economies, for example Ireland has an inflation rate of 0.5 percent. This leaves the ECB in a quandary: do they set policy based on Germany’s economy, or the struggling peripherals?

Twelve month Euribor rates have risen sharply since the start of this month, and are currently above 1.5 percent, more than the 1 percent above the ECB benchmark rate, suggesting the market expects the ECB to continue to normalise financial conditions. If, instead, the ECB decides to help the struggling European economies and keep interest rates lose, then Euribor rates would come off along with German bond yields, thereby threatening one of the main pillars of support for the single currency. But in the short-term while euro bulls continue to dominate the market, this is only a problem for the ECB.

Comments are closed.

  •