Wednesday, January 16, 2008

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.


Anonymous Anonymous said...

But if FED & Co manage to "stimulate" the economy (when inflation falls they will start an easy money policy)?

The US economy will then be "stronger" and the USD will rise against most currencies including the Euro?

Best Regards, Göran, Sweden

12:41 PM  
Blogger flute said...

One of the Euro's problems is that the Euro zone has very big differences between the participating countries. Just a quick look at Wikipedia's List_of_countries_by_current_account_balance shows this (the figures are for 2006, but the rankings are probably rather similar for 2007). At the top of the list we find Germany and the Netherlands with big surpluses, and further down on the positive side Finland, Belgium, and Austria. The rest of the euro countries ran current account deficits in 2006, with Spain, Italy, Greece, France and Portugal near the bottom of the list. In fact, Spain is the "worst" country in the world in this case after the undisputable winner USA. I haven't got the figures for 2007, but I believe you should look at how trade deficits for these countries (especially Spain) have developed for 2007 before being bullish about the euro.
Just a quick Google news search turned up the following articles for example:
France headed for record 2007 trade deficit,
Spanish [...] c/a deficit swells

9:26 PM  
Blogger stefankarlsson said...

Well, we'll see, but I don't think that will happen for reasons I explained in my ”Fed losing it” post.

9:42 PM  
Blogger stefankarlsson said...

Flute: I did mention in the post that it was likely that the trend was different in the rest of the euro area. But the fact remains that the increased surplus in countries like Germany, Holland and Finland for the most part haved outweighed the increased deficits in countries like France and Spain.

The November number for the euro area as a whole is not yet available, but in October 2007 the 12 month surplus was €29.5 billion, compared to a 12 month deficit of €22.8 billion in the 12 months ending October 2006.

9:50 PM  
Blogger flute said...

Stefan, thanks for the link to the ECB stats. You are right about the totals being on the positive side for October, but take a look at the chart in and you'll see that it's not that obvious where the longer term trend for the euro area is heading. The trend is positive for the 12 months, but it could very well turn back downwards again, if e.g. the current account deficit in Spain grows faster than the surplus in Germany. So I find making a prediction for the euro a rather uncertain business, though my bets are also on the euro if we compare it to the US dollar.
I tried to find historical data per country too (to see the longer term trends for Germany and Spain), but couldn't find it tonight anyway.

11:28 PM  

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