Finance Weblog: The Dollar, the Euro and the Pound: Structural changes or short term movements?

Abril 30, 2007

The Dollar, the Euro and the Pound: Structural changes or short term movements?

Juan Toro

Exchange rates are in turmoil. This week there are some historical highs and next week we might see others (probably on the same currencies). The Dollar is at historical lows relative to the Euro and the pound. You get now 1,36 dollars per Euro and 2 Dollars per each sterling you have in your pocket.

This turmoil seems that is better explained by a US dollar problem: low growth and high external deficits in the US. Moreover and related with these arguments there is an expected reversal of the returns on each currency. The monetary/interest rate cycle is expected to reverse, with the Fed probably lowering rates (despite the stubborn and firm resolution of the Fed against this market view) and the UK and Euroland going towards further hikes. In the UK higher than expected inflation is motivating higher rates. Whereas in Europe –though inflation seems contained- the activity figures released recently show a higher level of growth than expected.
But looking at this a bit deeper, there seems to be more structural reasons that sustain and explain the current trend. We previously referred to the Dollar/Pound current exchange rate as a historical high though this is actually not true. In 1945 the British pound was pegged to the dollar at $4, being devalued twice in 1949 and 1967 to $2.8 and $2.41 respectively till its flotation in 1972. Since then it depreciated slowly till the oil discovery in the North Sea. It then stabilized for a while till the Soros’ attack on the pound that pushed it to $1.57. But recently, it has gained the attraction of many asset allocators because of the long and stable expansion that the UK has enjoyed since 1992. This has given the pound the status of reserve currency and 12 % of world government deposits are now held in pounds. So its recent trend seems to be justified both on short term movements as well as long term expectations.

In relation to the Dollar/Euro exchange rate, there is a short term argument to explain the strength of the European currency but there also seems to be structural factors that sustain a robust Euro. The short term arguments are the same as those referred to when discussing the pound exchange rate. The Fed has stopped hiking and the ECB has still some movements to make shrinking the return spread differential between these two economies (and possibly inverting the current sign of that spread). But there are some longer term reasons that sustain the current Euro strength. According to a recent research by the Deustsche Bank, there are fresh changes that seem structural and could sustain the current forex values. The potential growth in the US economy seems to have drifted down in this last expansionary period whereas that of Europe has increased. This implies that the potential growth differences between both areas have narrowed and this might justify the current exchange rates as a more long term phenomenon.
Whether these exchange rates variations are temporary or long term movements still needs lots of discussions. The only real question now is what is the horizon of a short term phenomenon and how long will we live with these rates.