A brief look at a long-term chart for EUR/USD, which expresses the value of the euro in terms of the U.S. dollar, would suggest that the euro has effectively “gone nowhere” since its inception (as shown in the chart below). The vertical line in the chart marks the start of January 1999 when the euro was launched (the currency was considered “invisible” for the first few years, only used for accounting purposes and electronic payments).
From its initial launch, the euro sold off aggressively. The euro has always been viewed with great skepticism, although its riskiness enabled the currency to rally into its peak above the 1.60 handle (coinciding with the Global Financial Crisis). Since then, euro skepticism has been strong. In 2020, however, EUR/USD has managed to break its long-term downward trend by reverting to the upside after the U.S. Federal Reserve cut its short-term rate target to 0.00-0.25% (the ‘zero lower bound’).
From the chart above, we might think that the euro waxes and wanes as we would expect from all currencies and that no clear long-term trend (since inception) is discernible. Yet this is a myopic, dollar-focused view. While EUR/USD is the most liquid currency pair in the world (due to the sheer volume of trade; understandable given the size of the U.S. and European economies), the euro has more broadly been in a secular bull market.
This becomes clear when we look at Europe’s main trading partners. These include the following:
(Source: European Union)
I construct the table below using EU data, while also adding the final two columns to draw attention to these trading partners’ currencies. I add a percentage column to signal the weight of trade represented by the economy in question (i.e., the “total trade” divided by the aggregate total trade of all ten countries in the table). Using these exact same weights, I construct a weighted exchange rate index for the euro, illustrated below. (I concede that these weights are for EU-27 trade rather than EU-19, but they are fair to use for our purposes.)
As shown, the euro has spiked recently, yet since the inception of the common currency, it seems to have performed quite well. From a global perspective, we might venture as far as to say that the euro has been a safe place to park cash. Of course, a dollar-centric view would not render the same opinion. Of the currencies used in the index above (which admittedly use the same 2019 trade weights throughout this period), the euro has gained (in order of strength) against the Turkish lira, Russian ruble, Indian rupee, British pound, Norwegian krone, the U.S. dollar (yes, USD), South Korean won, and Japanese yen. Indeed, only two currencies (in the set of ten currencies) have strengthened against the euro since the year 2000.
These two currencies are the Chinese yuan and the Swiss franc. I have discussed the problem of the Swiss franc in a recent article and prior articles.
We can further contextualize the chart above by considering Purchasing Power Parity. Using the OECD’s PPP model data (which enables us to calculate an implied fair value based on the international purchasing power of the euro in terms of these currencies, on a trade-weighted basis) we can see that the euro has been undervalued for a long, long time (in spite of its strength).
The upper and lower bands, around the dotted black line (which represents our weighted PPP index, or implied fair value), represent 30% deviations to the annual fair value estimate. The most recent estimate is based on 2019 PPP data. The red line represents our weighted exchange rate index (the same as illustrated in our penultimate chart). Notice that the euro has, on an exchange rate basis, is still below its weighted fair value (as implied by PPP, which is based on relative trade factors). The secular rise in the fair value has been helped by lower inflation in the euro area over time.
This is all rather impressive considering that the ECB maintains a negative deposit facility rate of -50 basis points, and where the German 10-year bund yields less than -60 basis points (at the time of writing: -62.8 bp). Currencies such as the lira have collapsed, most prominently this year, and the lira is a good example because, in spite of its high short-term rate (its one-week repo is 10.25%), Turkey’s year-over-year inflation is currently 11.75%. That is, based on the data that is available to us. In other words, it is a negative-yielding currency when you consider inflation. The euro is also negative-yielding, but the negative deposit facility rate of -50 bp compares to deflation of -30 bp in October 2020. In other words, the euro is a higher-yielding currency than the lira in October 2020, after adjusting for inflation.
The euro is not only less risky than the lira, but also a higher-yielding currency. It is no wonder that EUR/TRY is rallying. The euro also benefits from the broader nominal interest rate normalization this year to the zero lower bound. The spike in EUR/USD has consolidated the euro’s strength and ability to venture for higher levels still. While CHF remains strong as a EUR alternative and (even global) safe haven, the euro serves as a safe haven of sorts to currencies such as the lira.
I believe this alternative view is useful to traders because it shows that the euro is not the worst currency in the world to hold. In the new regime of effectively zero interest rates (based on the short-term targets of G10 central banks, at least), the euro still offers the potential for appreciation. Most recently, the euro has conceded some of its strength, including against alternative safe havens such as the Japanese yen (see below).
However, much of these short-term moves can be partly attributed to short-term event risk (e.g. U.S. presidential election, Brexit, etc.), as well as macroeconomic uncertainty. The latter also tends to create oil price weakness too, and it has recently, yet the euro area itself is a net importer of crude oil products. Any euro weakness (driven by macroeconomic uncertainty) should therefore catch some support from the oil price weakness.
Looking forward, I would suggest not giving up on the euro just yet. The euro could continue to consolidate higher, and not just against high-risk currencies such as the lira. It is an alternative to the U.S. dollar.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.