US bear market may be the best hope for the euro

By Mark Cliffe
Click to follow
The Independent Online

The ailing euro will have to fight its own corner. After the initial success of last month's intervention by the G7 central banks, the euro has sagged to new lows on the foreign exchanges. Last week's frank comments by European Central Bank (ECB) president Wim Duisenberg have cast doubt on the willingness of the banks to continue to use their foreign exchange reserves to support it. A meaningful recovery in the euro's exchange rate will be even more dependent on investors switching their allegiance from US to eurozone assets.

The ailing euro will have to fight its own corner. After the initial success of last month's intervention by the G7 central banks, the euro has sagged to new lows on the foreign exchanges. Last week's frank comments by European Central Bank (ECB) president Wim Duisenberg have cast doubt on the willingness of the banks to continue to use their foreign exchange reserves to support it. A meaningful recovery in the euro's exchange rate will be even more dependent on investors switching their allegiance from US to eurozone assets.

The two factors that lay behind the initial success of the G7 central bank intervention to support the euro a month ago are now in doubt. Foremost was the participation of the US. The market's thinking was that the US Treasury would not be prepared, so close to the November elections, to compromise its "strong dollar" policy by intervening to drive the dollar down.

The US Treasury was persuaded to lend support to the ECB by reports of the damage that dollar strength had been doing to US corporate profitability. US participation was an important signal of its policy priorities, and a boost to the credibility of the intervention effort, given the success of previous intervention episodes in which the US has been involved.

However, over the past week Mr Duisenberg has revived the market's original doubts about the US commitment to the euro support effort. He admitted that the timing of the intervention was influenced by the timing of the elections. Worse still, he revealed that he had tried, but failed, to persuade US Treasury Secretary Larry Summers to soften the language of his mantra that "a strong dollar is in the interest of the US".

The other factor was the element of surprise. The rhetoric ahead of the intervention had left the markets sceptical about the likelihood of joint intervention, and the timing, ahead of rather than after the G7, caught the market on the hop. Although the G7 retains the ability to spring a surprise on the precise timing of further intervention, the markets are now on the look-out.

Mr Duisenberg has weakened the threat of intervention by his admission that the intention was not so much to boost the euro's exchange rate as to stabilise it. This matters to the markets, since it eliminates the threat that policymakers are intent on inflicting losses on those betting against the euro.

The ECB's main problem is that the decline in the euro has owed little to speculative flows. Instead, it has reflected "real money" flows of investment, which are less readily turned around. This means a recovery will require a fundamental rationale. In particular, it will require a shift in perceptions about the relative attractions of US assets.

Unfortunately, the market's psychology is such that a shift in favour of eurozone assets is unlikely. Whatever the ups and downs of the US markets, somehow the euro appears to come off second-best.

Consider the stock market volatility of the past few weeks. On the days when the US markets have been rallying, the euro has suffered. Yet on the days when they've been falling, the euro has found it hard to recover lost ground.

This is partly because many players see the dollar as a more convincing safe haven from market distress than the euro. This is particularly so given that one factor behind the weakness in markets has been rising oil prices. The thinking behind this is that since oil is denominated in dollars, this creates a demand for dollars. Moreover, if US technology stocks are seen as overvalued, their European counterparts are seen as even more so.

However, this argument can only be pushed so far. The fact is that the US has much more to lose from a generalised slowdown in tech spending. Not only is the US tech sector much bigger than Europe's, but European investors have a much bigger stake in it than American investors have in Europe's.

Over the past decade, capital flows have been running out of Europe into the US. That's why the euro has slumped. The European capital inflow into US securities markets has exceeded the US outflow into non-US securities to the tune of $140bn (£97bn) since the introduction of the euro at the start of 1999. Sadly, the euro's best chance of a convincing recovery would be a knock-out blow to US asset markets.

Mark Cliffe is chief economist at ING Barings

Comments