the EuroTrader Homework: A History of the Euro - Part 2. Photo: Peter Linke (Flickr).

Trader Homework: A History of the Euro - Part 2

Our Trader Homework series provides key trading theory, history and analysis for traders to swot up on in their spare time. Following his excellent history of the British Pound, FX Trader Yvan Berthoux now follows that up with a detailed overview on the history of the Euro and Eurozone. Here he continues with Part 2...

Read Part 1 below...

Trader Homework: A History of the Euro (Part 1)

PART 2. Study of trends, reversals and main drivers of the single currency since Inception

A. January 1st 1999: the launch of the Euro and the constant three-year depreciation

After four decades of effort, the single currency was born virtually in 1999 and in 2002 coins and notes began to circulate. At that time, there were 11 members and the US Dollar was trading at an initial value of 1.1685 against the Euro (the Pound was buying roughly 1.42 Euros at that time). However, the single currency suffered three years of depreciation against the US Dollar after its launch and hit an historical all-time low of $0.8230 in October 2000 according to Bloomberg data (chart 1).


Chart 1. EURUSD historical monthly candlesticks (Source: Bloomberg). CLICK TO ENLARGE

There have been many explanations for the Euro 1999-2002 depreciation; some economists used the productivity differential to explain the USD/EUR exchange rate (Corsetti and Pesenti, 1999, Chinn and Alquist, 2002 Schnatz et al., 2004), others used a set of macroeconomic variable – growth rate, inflation differentials, current accounts – (De Grauwe, 2000, De Grauwe and Grimaldi, 2005), or a surge in the equity market capitalization in the US since the mid-1990s leading to a large positive demand shock and a US Dollar appreciation (Meredith, 2001).

Even though these explanations could be convincing broadly financially speaking, most of them fail to explain the Euro weakness (vs. the US Dollar) empirically. Therefore, the depreciation of the Euro from 1999 to 2002 remains a puzzle and a fair conclusion to that depreciation period could be that the single currency wasn’t perceived as a full-pledge money by consumers and investors until the introduction of Euro coins and notes in 2002 (Shams, 2005).

B. The 2002 – 2008 appreciation

After notes and coins came into circulation (and national banknotes and coins were finally withdrawn from use), the Euro started its appreciation period against the greenback and almost doubled in value in 7 years; it soared from a historical low of 82.30 cents vs. USD to a historical high of $1.6040 reached in July 2008.

As the Euro Area GDP quickly reached 10tr USD in 2004 (vs. 12.5tr USD for the US at that time), it became the second world’s largest economy and therefore the importance of the Euro as an international currency was starting to increase. There are several explanations to the Euro appreciation against the USD:

1. Divergence in the Current Accounts
Between 2000 and 2007, the US Current Account deficit widened from 4% to 7% of the country’s GDP (bar chart 1), while the EZ Current Account was improving and slightly positive (+1% of GDP in 2004).

Bar Chart 1. EZ (top) and US (bottom) current accounts (% GDP) (Source: Trading Economics). CLICK TO ENLARGE

The large CA deficits could have been partially explained by the fact the US has a low savings rate (Summers, 2014); the deterioration of the national saving rate (percentage of GDP that entities in an economy such as households, businesses and governments themselves save over a fixed period of time) between 1990s and 2000s has led to increase in the current account deficits in the US (a current account deficit is the difference between national savings and national investments, the deterioration of the national savings).

2. A Weak US Dollar
This period was also associated with a long weak US Dollar period. The greenback was not only depreciating against the Euro, but most of the currencies (Cable rose from $1.40 to over 2.10$ during the same period; USDJPY went down from 120JPY to 70JPY…). This period was also very significant for commodities; gold soared $300 to $1,000 an ounce while oil went up from $18 to over $140 a barrel.

3. Interest rate differentials
Another explanation relies the interest rate differentials between Europe and the US; as European interest rates were relatively high compared to US interest rates, it attracted capital inflows in Europe and therefore contributed to the Euro strength.

4. Strong European growth
During the 2002-2008 period, the Euro Zone was experiencing strong growth – especially between 2006 and 2008 – and was the engine of global demand growth. Housing and Consumption bubbles in many peripheral countries (Spain, Portugal, Ireland…) generated the so-called positive feedback loop and fuelled its growth.

In many ways, it looked like the Euro Zone was stepping into the role of the US had previously played in the global economic system. Some even argued if the single currency will eventually surpass the Dollar as the Leading international currency (Chinn and Frankel, 2005). In their paper, the authors stated that if the US Dollar depreciation persisted in the future and if an important member joined the EMU (i.e. the UK), the Euro may have surpassed the Dollar as a leading international reserve currency by 2022.

C. The 2008 GFC and the Dollar rise.

In the summer of 2008, investors started to look for safety as the threat of a global failure in the system was starting to emerge sharply. Due to the search for safe-havens, both the global flight to safety into US Treasuries and the reversal of the carry trades were sources of Dollar strength. The Euro lost 23% (and 34% resp.) against the US Dollar (v. the Japanese Yen resp.) between the summer 2008 and Q1 of 2009 (chart 1).

In addition, the Dollar asset writedowns left European banks and institutional investors outside the US with overhedged Dollar books; therefore, squaring their positions required those institutions to purchase US Dollars, and therefore boosted the greenback’s appreciation (McCauley & al., 2009). In those panic moments, investors tend to look for safe-havens and the first questions that come to their minds are: What’s cheap and what’s liquid? The fact that investors bought US Dollar (and Treasuries) in the turn of the year 2000 (after the dotcom bubble popped) played also an important behavioural empirical bias.

To conclude, there was also a Dollar shortage after Lehman’s failure in September 2008 that reflected unbalance growth in international banking. As the BIS explained, European banks accumulated dollar assets well beyond their dollar deposits and funded the difference in the interbank market. The banking system suffered from a dollar shortage and the incredible spike in the 1-month and 3-month Yield premium in US Dollar swaps (Figure 1) contributed to a sharp appreciation of the US Dollar.

Figure 1. Libor and Dollar swap yield premium (Source: BIS). CLICK TO ENLARGE

D. Post GFC: Sovereign Debt Crisis, ‘twin’ deficits, bailouts…

After the 2008 financial crisis [and before May 2014], three major drivers could explain the EURUSD dollar fluctuations:

1. The spreads between peripheral and core Euro Zone countries (the first popular one to arise was the German-Greece 10-year spread in 2009/2010, then the second one was the German-Spanish 3-year spread during 2011/2012).

2. The ECB-Fed total-asset ratio: looking at the central banks’ balance sheets have become popular after 2008, and therefore the ratio between the ECB and the Fed’s balance sheet total assets was an important indicator to look at during that period. The higher the ratio (ECB balance sheet is increasing relatively to the US one), the weaker EURUSD.

3. The last indicator was current account differences (between US and EZ). As a consequence of the financial crisis, peripheral European countries were left with massive current account deficits – i.e. 15% in Greece or 13% in Portugal – which obviously accelerated the outflows from Europe and depreciated the currency.

On the top of that, after the establishment of a rescue fund (EFSF and EFSM first, then the ESM in 2012) to assist countries that couldn’t borrow from the market, it took some time for market participants to ‘digest’ it as there was speculation that the maximum lending capacity of €500bn was clearly not enough if EZ countries were falling one by one.

More and more countries were considered as recipients [of an ESM bailout] and less and less countries were considered strong guarantors; the Euro Zone was constantly making the headlines between 2009 and 2012 which was each time impacting the Euro.

1. 2011 first shot: introduction of new LTROs
In response to the European sovereign debt crisis, the ECB announced a new ‘version’ the long term refinancing operation (LTRO) – a cheap loan scheme for European banks – towards the end of 2011.

By definition, the LTROs provide an injection of low interest rate funding to euro zone banks (using sovereign debt as collateral on the loans) and are used to provide longer-term liquidity than standard MROs (main refinancing operations) to banks during times of crisis.

Before the financial crisis, the ECB’s longest tender offered was just three months and represented about 20% of the ECB’s liquidity provided. After the crisis hit, the maturity of these LTROs was extended to six months (March 2008) and 12 months (June 2009).

Then, the two rounds that were carried out in December 2011 and February 2012 were expanded to a three-year maturity with a 1% interest rate and the option of repayment after one year. In total, the ECB LTROs provided more than 1 trillion euros of liquidity to euro zone banks to stave off the credit crunch and on hopes that the situation improves (i.e. decrease in peripheral yields).

But the situation deteriorated;, the Euro went down from a lower high of 1.50 (against the US Dollar) in mid-2011 to retest the $1.20 in the summer of 2012 (chart 1 above).

At that time, the ECB balance’s sheet was expanding (thanks to the LTROs) and reached a high of €3.1 trillion in June 2012 (chart 2) while the Fed’s balance sheet was steady after QE2 ended in June 2011 (Operation Twist lasted from September 2011 to December 2012 but didn’t increase the size of the central bank’s balance sheet).

Chart 2. ECB (white and blue line) versus Fed (yellow line) balance sheet (Source: Bloomberg). CLICK TO ENLARGE

In addition, peripheral yields of European countries rocketed during that period; the Italian and Spanish 10-year bond yields were trading at 6.5% and 7.5%, respectively, in the summer of 2012. Investors started to worry that the ESM rescue fund wasn’t strong enough to support countries like Spain or Italy and were starting to fear potential defaults coming ahead. This was clearly not sustainable; Italy was (and is) not able to roll its obligations at a 6%+ yield without and the markets needed a reaction at that time.

2. July 2012: ‘Whatever it takes’ and the introduction of the OMT program
Therefore, that leads us to the famous Draghi’s ‘whatever it takes’ at an investment conference in London on July 26th 2012 (and the extra comment ‘we think the Euro is irreversible’) with the introduction of the OMT (Outright Monetary Transactions) program on August 2nd.

Even though the OMT was [and still is] considered as a myth by many practitioners and economists, it was ‘enough’ to reverse the trend on peripheral European bond yields, and therefore the Euro. Until May 2014, the Euro became one of the traders’ favourite currencies (with the British Pound).

However, in a world where every economy wants a cheap currency, the Euro strength was starting to pause a problem for EZ politicians and policymakers, as inflation expectations were falling towards zero. The 5Y5Y inflation swap rate fell below the 2-percent level (the ECB’s target) in 2014 as you can see in chart 3, increasing doubts on the ECB only mandate. In addition, the Euro strength was causing competitiveness problems for peripheral countries.

Chart 3. ECB balance sheet (White and Blue line) overlaid with 5Y5Y forward inflation rate (Yellow Line) (Source: Bloomberg). CLICK TO ENLARGE

E. May 2014: ‘Ready to Act’ and the end of a Euro love story

On May 8th 2014, Draghi announced during his conference that the ECB was comfortable with taking new fresh action (i.e. QE + Negative interest rate policy) at the next meeting in June in order to tackle the lowly inflation rate (and send the Euro down).

After that meeting, the ECB decided to go all-in in the next few months and entered into the Currency War Game. At that time, US monetary policy and European monetary policy flipped at the same time (chart 2): while the Fed was tapering its QE3 by 10-billion dollars every month, the ECB announced the market that it will take further measures. The reaction on the Euro was imminent, and the single currency went down from a lower high of 1.40 during that meeting (May 8th) to close at a low of $1.21 at the end of the year 2014.

At the June ECB meeting, Mario Draghi announced a series of measures [as promised] that included cutting the deposit rate into negative territory (-0.10%), targeted LTROs, an extension of the fixed rate full allotment and preparation of European QE. The ECB ‘bazooka’ was finally announced on January 22nd 2015, planning monthly purchases of €60bn of private and public sector debt between March 2015 and September 2016 (bringing the QE size to 1.1tr Euros). The expanded asset purchase program (APP) – i.e. QE – is split in four different categories, which are (ECB website):

  • Third covered bond purchase programme (CBPP3)
  • Asset-backed securities purchase program (ABSPP)
  • Public sector purchase programme (PSPP)
  • Corporate sector purchase programme (CSPP)

The Euro continued its negative trend against the US Dollar to hit a low of $1.0450 in March 2015; since then, the pair has been oscillating mainly within the 1.05 – 1.15 range (chart 1 above), with the exception during the August 24 flash crash in 2015 where the Euro soared with the VIX and rose above 1.17 against the US Dollar.

One explanation of the positive 20-day correlation between EURUSD and VIX index could be that investors holding European assets such as stocks or bonds (in response to more stimulus) were all hedged (i.e. short EURUSD).

Therefore, when the market crashed in August 2015 (Eurostoxx 50 plummeted 20%, chart 4), investors had to buy back Euros in order to not be overhedge, therefore pushing the Euro to higher levels.

Chart 4. EuroStoxx historical daily prices since QE announce (Source; Bloomberg). CLICK TO ENLARGE

Current state of the Euro?

Despite Mario Draghi constantly ‘denying’ about tapering, the ECB already started to reduce its monthly purchases from 80 to 60 billion Euros in December 2016. It looks like policymakers are very careful about the expressions they use at each conference based on a fear of a potential market reaction since taper tantrums (Q2/Q3 2013 in the US, and April/May 2015 in Europe).

The repricing of growth-inflation story in Europe, with the employment rate falling to 9.1%, its lowest rate since February 2009 and a GDP growth rate of 2.1% over the past year, has led to few [speculative] conclusions that the ECB will announce a(nother) tapering plan later on this year. Even though the inflation’s forecasts are still below the ECB’s 2-percent target, we can notice that the core inflation rate has been picking up over the past few months (1.3% in August, its highest level since 2013), hence policymakers could use that trend in addition to strong growth momentum to potentially slow down the QE program.

The European [macro] outperformance has pushed equities and long-term yields higher, but especially the Euro, which has been up 14% YtD against the greenback. The Euro, which has a 57.6 % weight in the US Dollar index, has been the main currency responsible for the 10-percent US Dollar weakness since the beginning of the year.

The exchange rate is trading at a 2-year-and-8-month high, and it looks like the currency may be subject to a short term consolidation over the next quarter Q4 2017. We are looking at the 1.1550-1.16 region for the consolidation, which started over the week end with German elections with Chancellor Angela Merkel securing a fourth consecutive term in the Bundestag, but far-right party Alternative fur Deutschland gaining seats in the parliament. Political Uncertainty (i.e. Catalonia) in addition to central bank jawboning (on the Euro being to expensive) will continue to weigh on the single currency.

Yvan Berthoux is an FX Trader based in London. You can read more of his analysis at