Tuesday, August 03, 2010

Reflections On Recent Exchange Rate Movements

The exchange rate between the euro and the U.S. dollar has been going through something of a roller coaster ride the last few years. After having strengthened from $1.18 in 1999 to $0.83 in 2002, the Euro then appreciated (interrupted by a few minor stebacks) to as high as $1.60 in July 2008. Then it fell to as low as $1.25 in March 2009, only to appreciate to about $1.50 in November 2009. Then it started to fall dramatically again, to $1.20 in June 2010. But since then it has risen again to $1.323 (when this is written, when you read it it might have changed somewhat).

The point of this point is not to create a full explanation of all of these ups and downs, but rather a explanation of the most recent rally.

There are basically two explanations. First of all, during its lows during the European debt panic, the euro was heavily oversold, while the U.S. dollar was overbought. Many traders over-reacted, owing in many case to trading programmes (with automatic selling rules).

And secondly, it has become increasingly clear that markets have been too optimistic about U.S. growth prospects and too pessimistic about European growth prospects. Yesterday's manufacturing survey's illustrated this, with the U.S. survey continuing its downward trend, and the Euro area survey resuming its upward trend. Other reports from Europe and the U.S. confirm a cyclical upwing in Europe and a cyclical downturn in the U.S.

This basically eliminates the risk/chanse of a Fed interest rate hike, while improving profit opportunities in Europe, thus leading investors to Europe.

To some extent, this movement might be self-preventing as the renewed euro strength and dollar weakness will make life more difficult for European exporters and more easy for American exporters. This is especially true given the negative effect that a stronger euro will have on European governments with excessive debt. However, increased exchange rate uncertainty
will hurt companies on both sides, and the negative effects on European exporters will to some extent be mitigated by positive effects for importers (and vice versa for American companies).