Sticklers for value have plenty of reasons to frown at financial markets. Much feels out of order, from squashed bond yields to pricy stock markets. But currency markets, at least, seem to have shifted in line with fundamentals this year.
Take the euro, for example. Since the start of 2017, it has risen by almost 15% against the US dollar, to $1.19. That has taken it much closer to fair value by benchmarks like purchasing-power parity (PPP), the exchange rate at which a basket of goods is worth the same in different countries. The Organization for Economic Cooperation and Development puts the euro’s PPP at $1.33. That’s a significant rise from $1.04 in January.
“The elastic had to snap back,” said Kit Juckes of Société Générale, a French bank.
Of course, the euro’s revival is a result of more than its being cheap. The anxiety that elections in Europe might bring to power anti-euro populists, like Marine Le Pen in France, has dissipated. The eurozone economy has further strengthened, raising the prospect that monetary policy will soon be less accommodating.
Even so, the European Central Bank (ECB) seems in no hurry to fulfill these hopes, in part because of the euro’s recent surge.
The flipside of euro strength is a weaker US dollar. The dollar surged in the weeks after the US presidential election in November on a belief that big tax cuts were likely and that a fiscal stimulus of this kind would oblige the Federal Reserve to raise interest rates more quickly than otherwise, pulling capital to the United States and lifting the dollar.
Hopes of tax reform have been dashed. In fact, the US economy has underperformed. The International Monetary Fund, for instance, revised its forecasts for GDP growth downward in July. A series of surprisingly weak inflation figures has made the Fed more cautious about raising interest rates.
All of these developments have hurt the dollar. Since the beginning of March, it has fallen by 6.5% against a broad basket of currencies weighted by their importance to US trade.
This is good news for the world economy. A weakening dollar has given a recovery in emerging-market economies room to breathe. A weak dollar allows for cheaper borrowing in dollars in global markets. Central banks have been able to cut interest rates without worrying that the action will weaken their own currencies and stoke inflation.
The global appetite for risk-taking has also helped. When investors are cautious, they cling to “safe haven” currencies, like the dollar, yen or Swiss franc. But when the volatility index (the Vix, or fear index) falls, the riskier (“risk-on”) emerging-market currencies tend to do well, according to Kevin Daly of Goldman Sachs.
© 2017 Economist Newspaper Ltd., London (September 9). All rights reserved. Reprinted with permission.
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