The euro is still looking overvalued

Kathleen Brooks
THE euro has taken a breather. After a steep decline last week the single currency has gained some ground against the US dollar, and has stabilised around the $1.24 level. This has commentators asking out loud if the euro is now due a correction higher.

But is it a good time to take a long position in the euro or could there be more weakness ahead for the single currency? Although the €750bn bailout orchestrated by the European Union (EU) and International Monetary Fund (IMF) has alleviated concerns about short-term liquidity issues for Greece, Spain, Portugal and Ireland, the latter seems to be the most likely scenario.

Firstly, the euro remains over-valued even after its steep sell-off. “One euro is still worth more than one dollar, which doesn’t make sense,” says Michael Hewson, currency strategist at CMC Markets. According to analysis by Capital Economics, the euro also needs to fall some way on a purchasing power parity (PPP) basis against the dollar (see chart). At current levels a euro will buy you less in Europe than a dollar will buy you in the US. For the euro and the dollar to reach parity, according to this model, the euro would need to fall below €1.20.

Whether or not the euro is overvalued is crucial to the recovery of the world’s largest economic bloc. Currently the euro is less competitive than the dollar, which could hamper export growth in the region.

The euro could also come under pressure from rising interest rate differentials. The European Central Bank is expected to keep interest rates on hold to help Europe’s weak economies as they try and adjust to more frugal times. The US economic recovery has gained pace and the Federal Reserve could be the next central bank to raise rates. Since the foreign exchange markets are extremely sensitive to changes in interest rates, a narrowing of the interest rate differential between the euro and the dollar would only add to its woes.

A new wave of uncertainty surrounding the Eurozone bailout funds and how they will be distributed is waiting in the wings and could easily de-rail the recent stabilization of the euro. On Monday a measure passed unanimously in the US Senate that would see the US, the IMF’s largest donor country, veto bailouts for countries that are unlikely to pay the funds back. The move comes amid concern in the US that taxpayer funds are indirectly being used to bail out Greece through the IMF. This is significant since the IMF has signed up to $310bn of the original $1 trillion European bailout fund. “The IMF portion of the funds have been thrown up in the air by the US Senate, although it hasn’t seemed to register with the market yet, it’s a worry since the bailout funds might not actually be there,” says Hewson.

If the bailout is meant to be the glue that holds the troubled Eurozone together, then without it the whole project could fall apart. And as long as there are fears that the euro could get broken up, then the single currency is likely to come under more pressure.