By Charles Ross, ContributorIN OUR last article we looked at the performance over the last year of Euro-denominated bonds against US dollar bonds. We focused, in particular, on the appreciation of the Euro against the US dollar. Let's now look at the reasons for these gains by the Euro.
Changes in the relative values of international currencies are thought to conform, over the medium to long term, with the interest rate parity theory otherwise known as the International Fisher Effect. This theory is based on the assumption that, in a free and open market, it will not be possible for arbitrage opportunities to exist for prolonged periods. An arbitrage opportunity, in this context, simply means a risk free way of making money. The theory is therefore based on the assumption that an investment in a financial instrument in two countries that have freely floating exchange rates will earn the same return, over time. In other words, if the interest rates in these two countries are different, their exchange rates will adjust, over time, to bring the returns on the investments into equilibrium.
The theory is illustrated by the fate of the US dollar against the Euro over the last few years. Interest rates in the US were quite high in the mid to late 1990's, as the Federal Reserve sought to cool down an economy that was in the throes of a technology-driven boom. In 1999 when the Euro was introduced, rates in the European Union were much lower than the US and that currency fell steadily against the dollar, as the higher returns in the US and their booming stock market attracted funds into the US economy thereby increasing the demand for US dollars. However, this picture changed quite dramatically after the bursting of the Stock market bubble in the US and the subsequent slipping of that economy into a short recession. In 2001 the Federal Reserve reduced interest rates steadily and quite dramatically to levels not seen in 40 years. This brought US interest rates below those of the Euro zone countries and reversed the attractiveness of US investments as against investments in Euro-denominated securities. This contributed, in turn, to a rise in the value of the Euro.
While interest rate disparities are an important factor in assessing the relative values of currencies and in gauging the direction of future movements of one currency against another, they are not the only factor that has a bearing on these matters. The strength of the US dollar in the latter half of the 1990's was also the result of other aspects of US government policy and caused developments that have contributed to its current weakness.
FISCAL SURPLUSES
The fiscal surpluses of the Clinton administration helped to fuel the boom in private investment that drove the economic expansion and the rise in asset values during that period. The strong dollar made imports relatively cheaper and contributed to a growing current account deficit in the balance of payments that has now reached record levels (about 4% of GDP). The capital inflows that supported this deficit are now shrinking as the stock market has long since lost its lustre and interest rates are very low and may be going lower still. Furthermore, the fiscal surpluses have disappeared and the US government is now running significant deficits on its operations.
All this has led to a shift in US policy away from the Strong Dollar policy of the late 1990's to a policy of "the dollar as a reliable store of value". This recent policy change shifts the focus from the external to the internal value of the currency and has contributed to the recent weakness of the dollar against the Euro and other hard currencies. However, there is no guarantee that the dollar will continue to decline indefinitely. Currency movements do affect competitiveness and the Japanese government has already responded by intervening to prevent further depreciation of the US Dollar against the Yen. The European Central Bank has also lowered its interest rates by 50 basis points, in an attempt to both stimulate economic activity in the EU and to slow the rise of the Euro against the dollar.
The bulls and the bears are still arguing about how much further the dollar is likely to fall against the Euro and other major currencies, but there does seem to be a consensus that the dollar will remain weak for some time. The only certainty, though, is that, as with almost any market, the price of the currency will fluctuate.
Charles Ross is Managing Director of Sterling Asset Management Ltd. Please send feedback to sterlingasset@jamweb.net
