The Federal Reserve has been more proactive in printing money, known as Quantitative Easing (QE), than its European counterpart, which has been driving the dollar lower against the euro. In addition, the European Central Bank has kept a more hawkish stance, raising rates earlier this year – only to start reducing them again once the threat of a European recession became apparent. In periods of financial repression, like the current one, when rates will probably be kept low for an extended period of time, investors are likely to prefer the currency that provides a higher yield. This has been the case recently, with investors enjoying a positive yield differential by favouring the euro over the dollar.
It’s not just interest rates that are supporting the euro. The aggregate fiscal position of the Eurozone as a whole looks healthier than many other major advanced economies, including the US. The current IMF gross debt projection, for example, is much more favourable to the Eurozone than for the US. Moreover, with Capitol Hill gridlocked, the US lacks a credible fiscal consolidation plan.
Since its introduction the euro has also gained the status of reserve currency. As a consequence, governments and central banks have diversified their investments and foreign-exchange holdings away from the dollar and into the euro. Emerging markets, flush with cash from their exports, have been the largest contributor to this trend. Until now, this trend has shown little sign of losing momentum, despite the ongoing crisis.
A short-term technical factor has also contributed to the euro’s relative strength. European banks are currently going through an extensive deleveraging exercise that will probably continue over the coming months. For the moment, it looks like these banks have chosen to cut loans and credit lines outside the Eurozone. This has resulted in a repatriation of funds back into the Eurozone which has supported the euro recently.
Another factor is that the euro-zone’s external debt position is quite low, with only about 25 per cent of its gross debt held outside the zone. Only sales from bondholders based outside the Eurozone have had an effect on the currency.
Euro investors should not be complacent, however, as the euro’s comparative advantages look set to deteriorate. With a Eurozone recession looming, fiscal positions deteriorating and the ever-heightening risk of a euro member leaving the bloc, the currency’s helpful tailwinds could quickly peter out. The euro’s relative resilience, therefore, may prove transient.