James Montier
SHAREWORLD
The European Central Bank (ECB) finally managed to get internal consensus last week and raised rates to 3,75% from 3,5%. Essentially, the bank was in a lose-lose situation. If it raised rates it could be seen as panic induced by the weakness of the euro. A decision not to raise rates would have been interpreted as indifference to the currency and called into question the ECB’s anti-inflation credentials, given that March saw Euroland inflation exceed the ECB’s year-on-year upper limit of 2%.
The move did nothing to alleviate the pressure on the beleaguered currency. Why are investors so anti-euro? We haven’t yet heard the French complain of a British conspiracy to undermine the euro, but surely that will happen soon.
One of the key problems for the euro is that everybody has an opinion and a desire to express it. Euroland politicians and ECB officials have regularly clashed in public over statements on the “correct” level of the euro. Even within the ECB there are tensions over who should say what with regard to the currency. This lack of clarity over the official line has undermined the infant unit.
From an economic point of view a weak euro is just what the doctor ordered. It helps to underpin the incipient recovery within the Eurozone (as evidenced by German export orders, which are up 16% year-on-year), and shouldn’t really be hugely inflationary given the slack within European economies – Eurozone unemployment still stands at 9,5%. Until we see faster growth in the Eurozone, the euro looks fated to remain out of favour.
But the euro cannot be looked at in isolation. The flip side of its weakness has been sterling and dollar strength. According to the Bank of England index, sterling is at a 15-year high, while the Fed’s nominal measure of the value of the United States dollar shows the greenback is close to all- time highs.
Economists are generally unhelpful when it comes to forecasting future exchange rates. The standard model they use goes by the grand name of uncovered interest parity (UIP). Say British one-year interest rates are 7%, and Eurozone one-year interest rates are 4,5%, the UIP model says that sterling is expected to depreciate by 2,5% over the year. If that didn’t happen you could make money by borrowing in euros and depositing in sterling.
The goods news for you and the bad news for economists is: in general you can! UIP simply doesn’t work. In fact the evidence actually shows that the opposite of UIP tends to occur – currencies with higher interest rates tend to rise.
So when economists say sterling is 30% overvalued, it is not terribly helpful. Just because a currency is called overvalued by economists doesn’t mean it is about to collapse, much to the chagrin of the bears.
Those who have continually attacked the US stock markets valuations have often cited a dollar collapse as the trigger for an equity market crash. The US is borrowing about $1-billion a day from the rest of the world – what happens when overseas investors stop funding the US consumption habit? The dollar would collapse, imported inflation would soar, bond yields would rise dramatically, consumption and investment would suffer a major setback, plunging the US economy into a recession. The stock market would get a double whammy – rising bond yields undermining valuations and an appalling earnings outlook. This is the stuff of nightmares.
However, back in 1985, Paul Krugman devised a sustainability test to see if a currency was overvalued. The test essentially came down to a race between improvement in the trade deficit (as the currency declines) against the increasing burden of interest payments on external debt.
Investors need not worry about the details, but they should be able to take comfort from the results. Applying the Krugman test to sterling and the dollar shows both currencies can sustain the levels they are at given current real interest rate differentials. Stories of the impending collapse of both the dollar and sterling are the pipe dreams of market bears.
Of course, currencies and exchange rates are not the exclusive province of fund managers and investors. They matter in the real world too, and British manufacturing will have to come to terms with sterling’s strength. The simple truth is that current trends in the exchange rate markets look set to continue for some time.
James Montier is global strategist at Albert E Sharp Securities