Not Just Failure, but Success Weighs on the Euro

Many observers are attributing the euro's weakness to concerns that the measures taken by the EU/ECB/IMF may fail to contain the crisis. There is surely an element of this. Yet that interpretation may rely too much on the foreign exchange market rather than the debt market, where the crisis began.

Looking at the dramatic rally in Club Med bonds, especially Greece and Portugal, suggests that the measures have succeeded reducing premiums and credit default swap prices. Money markets are seeing an easing of tensions as well.

To reconcile the weakness of the euro and the easing of liquidity concerns, one could conclude that it is not the risk of failure that is weighing on the euro but th risk of success.

If the efforts of successful, it will result in greater fiscal consolidation and weaker domestic aggregate demand in Europe. Rather than close the output gap may widen further. To offset the weakness in domestic demand, given the export orientation (as opposed to the US and Japanese build locally sell locally, foreign direct investment strategy), a further decline in the euro is desired and the likely result.

Recall that by most measures of valuation (e.g. OCED's PPP estimates, commonly used FEER and REER models) the euro is still rich. And coming down to fair value (roughly $1.15-$1.20) will unlikely be sufficient. The euro should be expected to fall below fair value, just as it has spent several years above fair value.

Part of the reason to expect an undershoot also is the contrasting performance of the US economy. It has recorded two consecutive quarters of above trend growth and two consecutive months of more than 200k jobs. More Americans are working, a modestly longer work week, earning a little bit more an hour. The wholesale sales and inventory figures out on Tuesday showed sales still rising faster than inventories, resulting in a new low (since the time series began in 1992) in the inventory/sale ratio (1.13 months down from 1.16). This points to continued increase in output in the coming months. Even with a decline in auto sales (at th wholesale level) wholesale demand for durable goods rose 2% in March for a 13.7% year-over-year gain.