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Buy The Euro Ahead Of French Elections

March 10,2017 22:27

The eurozone's current account, trade balance, and FID inflows do not justify a weak euro. One reason for euro weakness might have to do with the political rhetoric throughout Europe. If so, with the ending of French elections, some portion of this ...and more »

Contrary to the British pound, the euro does not carry the same baggage. Meaning, it does not have the negative elements that warrant the euro trading so low against the dollar. According to market commentators and pundits, the euro is trading so low against the dollar on the back of interest rate differentials - meaning, because U.S. rates are higher. According to Federal Reserve senior economists however, this theory is false. Fed senior economist YiLi Chien, and FED research analyst Paul Morris explains: A common story connecting these two events is based on the argument that a high-interest-rate currency should appreciate relative to a low-interest-rate currency. If the Fed raises interest rates while other central banks maintain or even lower their interest rates, then the return on savings is more attractive in the U.S. than in other countries. Given this higher rate in the U.S., international capital should flow from other countries to the U.S., resulting in the dollar's appreciation. Do the economic theory and data support this story? A standard textbook theory-uncovered interest rate parity-argues exactly the opposite: high-interest-rate currencies should depreciate. And the Fed article concludes: Finally, there is weak evidence that a high-interest-rate currency actually has a tendency to appreciate, which is consistent with the story described earlier. In sum, the theory predicts that a rate hike in the U.S. should depreciate the U.S. dollar. In reality a higher interest rate may have very little or no effect on the exchange rate, given the strong empirical support of the random walk behavior of exchange rates in the short run. In a nutshell, according to the Fed, exchange rates are to a great extent random. And if the Fed - which has more data points than anyone on earth, and an armada of economists - says so, pardon me if I believe the Fed as opposed to Rick Santelli on CNBC.
And while I believe if the Fed raises rates aggressively, it will cause chaos throughout the world (please consider: Why The Fed Will Think Twice Before Raising Rates Much Further), nevertheless raising rates does not guarantee the dollar will go up. The fundamentals of the euro are more than sound 1) Don't pay attention to cheap political talk First of all let me clear some of the smoke as far as the future of the euro. For some reason many in the U.S. and the U.K. believe the euro will fall apart. This is not going to happen by a long-shot. Yes populism is on the rise everywhere, and many European politicians managed to get elected on the back of euro-skepticism. However once they get in power, then they change their stance. Don't take the U.K. as an example. The U.K. was never a member of the union at heart to begin with. Every time the European Commission wanted to do something, the U.K. always had to have some kind of exemption to not comply. Also, the U.K. was not part of the eurozone, so leaving had no monetary cost for the U.K. As for Greece, the communist government of Syriza got elected on the back of anti-European sentiment, only to break every pre-election promise they made once in power. And the reason is simple. On the one hand their promises didn't make any sense (economic or otherwise), and second, even they understand that if Greece were to exit the E.U., it would be a total catastrophe. So while there is still much euro-skepticism and anti-European rhetoric all over the place, in reality, it's nothing more than cheap political talk that is mainly produced for local consumption, because European politicians need to blame someone for the fact that they cannot deliver on their promises. 2) European accounts are more than healthy
source The euro-area balance of trade, and current account are more than positive. In fact the current account surplus stands at 3.7% of euro-area GDP. How can any currency be weak with such a positive current account? source: UN Investment report 2016 In fact, even on a global FDI inflow metric, the euro still shines. While Asia still receives the most in FDI inflows, Europe has been in second place for the last three years. So why is the euro weak vs. the dollar? Well I don't know, but I do not think it has much to do with interest rate differentials. While the dollar has reasons to be stronger against most currencies in the world (please read my article with the link above to understand why), it should not be this strong vs. the euro. It might be politics The other day I was watching CNBC, and a guest said that there is a bubble in political rhetoric. Not just in Europe, but in the U.S. also. I agree. It might just be that part of the weakness in the euro has to do with the negative sentiment coming from politicians, pertaining to the future of the euro. With French elections coming up in April, all eyes are on Le Pen and her anti-euro party. While she is expected to make it to the second round, I do not think she will even come close to winning. However even if she does, we will see a repeat of what has happened in Greece. And that is, the electorate will almost instantly regret voting for her (as Greeks have regretted voting for Syriza). Reason being, she will break every promise she ever made, and make an about-face on everything, especially daring to even consider taking France out of the eurozone.
And just as in Greece - where today you cannot find anyone admitting to have voted for Syriza - it will be a challenge finding French voters admitting they voted for Le Pan. Of course it's not just the French elections. The Italians are also disappointed with the euro. According to the latest surrey, only 41% of Italians think positive of the euro. And yes, just as in every other European country, Italy has its fair share of left and right wing radicals, promising pie in the sky, if only Italy left the EU and introduced the lira once again. However if politics are one of the reasons for euro weakness, when might the pressure be lifted? Well this is difficult, if not impossible to calculate. However, logic dictates that once the French elections are over, part of the political pressure on the euro (if politics are indeed the problem) should be lifted. Reason being, with the U.K. exiting the E.U., France is now the second largest economy in Europe. So if anti-European rhetoric subsides in the block's second largest economy, that should change the way market participants view the euro, since as I said it should not be so weak against the dollar. Bottom line Any way you slice it and dice it, the euro should not be trading so low against the dollar. If politics have anything to do with euro weakness vs. the dollar, then we should see some pressure lift after the French elections. However if the euro does not rally even after the French elections, then further investigation is warranted. I do not think the dollar shortage issue (a more layman's article here and here) should have an effect on the euro. And if market participants are buying dollar vs. euros, based on dollar shortage, then they are wrong and this miss -pricing will sooner or later be adjusted accordingly. Furthermore, the U.S. administration and U.S. politicians better be very careful they do not see a stronger dollar, because not only is a stronger dollar a prelude for a market crash, but a world recession (more about that in a future article).
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.

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