Trade Trends Provide Support For Euro Bulls

Sometimes it is argued that because the euro is higher than the various PPP values estimated by the OECD and others, this means the euro has to fall. But there is really no reason at all for such an assumption. Price levels often differ between different geographic areas, and these differentials are often very much sustainable. So, there is no direct reason for PPP to be relevant.

Indirectly, however, PPP could have an effect to the extent these differentials reflect differences in the prices of tradable goods. This will create an incentive for buying goods in low price countries and selling them in high price countries. This process will cause the real exchange rate of the high price country to fall. Note, however that this adjustment will partially take place through higher inflation in the low price country, rather than a higher nominal exchange rate. And note also that this will presuppose a weakening of the trade balance of the high price country. It is the weakening of the trade balance that constitute the process of lowering the real exchange rate of the high price country.

And we can certainly not see any weakening of the trade/current account balances of the euro area. Indeed, the euro area trade surplus appears to be rising rapidly. Germany for example saw its current account surplus rise from €14.8 billion in November 2006 to €20.0 billion in November 2007. Holland saw its trade surplus rise from €3.7 billion in November 2006 to €5.1 billion. And finally, Finland saw its current account surplus rise from €1.39 billion in November 2006 to €1.68 billion in November 2007. The total increase for these three countries add up to €6.9 billion. A swing that is even bigger in dollar terms because of the rise of the euro.

It is possible and perhaps even likely that the other euro area countries had a weaker development and saw its balances deteriorate. But it seems unlikely that the net change of these is even close to €6.9 billion, so when the total number for the euro area is released, it seems likely to show an increase in the surplus by several billion euros.

Combine this with the fact that the trade deficit have again started to rise in America and it is clear that trade far from supporting the case of euro bears, it support the case of euro bulls.

Add to this the fact that the ECB is likely to leave interest rates unchanged, while the Fed seems likely to cut interest rates agressively (The discussion about the next cut have changed from whether it will be a 25 or 50 basis point cut to whether it will be a 50 or 75 basis point cut) and it is clear that interest rate trends support the euro as well. Market interest rates (and soon also the official rate) are already lower in America even in nominal terms. Add to that the fact that inflation is much higher in America, and it seems clear that European bonds provide a far higher value than American ones.

The only thing limiting the euro's rise, aside from French and Italian politicians complaing about a too strong currency, is the irrational focus of some on PPP from some traders. Ultimately, though, the strong underlying fundamentals will push the euro well above $1.50.