Economic Research Department
No. 88 – February 19, 2008
The euro/dollar exchange rate and the fundamentals: how to
explain recent trends?
 The euro/dollar exchange rate has appreciated
by over 20% since end-2005. The rate at which the
euro currency has appreciated against the dollar
has picked up from mid-2007. Since then it has
fluctuated around record highs of between 1.451.48.
 The euro's appreciation against the dollar is
partly due to cyclical divergence between the US
and the eurozone. The sharp improvement in the
eurozone's economic environment with the closing
of the output gap has benefited the single currency
while the US economic slowdown has led to a
general softening of the dollar.
 Yield differentials between the United States
and Europe also justify a strong euro. Over the past
two years, the stance of monetary policies and
differentials in stock market performances on
either side of the Atlantic have leaned towards a
trend appreciation of the euro against the dollar.
 Variations in the euro exchange rate are due
not only to cyclical divergence, however, but have
deeper roots. Changes in fundamentals justify the
appreciation, even if a sort of over-adjustment
seems to have amplified the trend.
 For example, the bilateral basic balance between
the United States and the eurozone suggests a
euro/dollar exchange rate of around 1.40, but no
more than that. Using the PPP approach puts the
value at around 1.15-1.20, which suggests that the
euro is overvalued by 20-25%. Our mid-to-long term
econometric model based on broader fundamentals
(productivity gaps and net external positions)
suggests an equilibrium level closer to 1.30.
before a new spurt and a 6.5% increase against the
dollar in the second half.
Euro - dollar exchange rate
euro/usd
1,48
+23%
1,44
1,40
+6,5%
1,36
1,32
1,28
1,24
1,20
1,16
Dec-05
May-06
Oct-06
Mar-07
Aug-07
Source : Datastream, CA
Jan-08
euro - dollar
Cyclical divergence
The dollar falls and growth rates divergence
The euro has strengthened, but it is above all the
dollar that has weakened, and against most currencies. The US currency is suffering from economic
slowdown in the US, linked among other things to
the property recession there. Since the start
of 2006, US growth has slowed, whereas it has
tended to accelerate in the eurozone. Thus, while
the growth differential was long favourable to the
United States, this has changed in the past
18 months, and the gap is even tending to grow.
US- EMU: Real GDP growth
6
%, y/y
5
4
3
2
The facts: a trend appreciation
The euro has showed a trend appreciation against
the dollar for the past two years and more. Between
January 2006 and January 2008, the euro rose by
over 20% against the greenback. The trend is not
straight-line, however, as periods of respite alternate
with spurts. In the first part of 2007, for example, the
euro/dollar exchange rate appreciated by only 3%,
1
0
96
97
98
99
00
Source : Datastream, CA
01
02
03
04
US - Real GDP
05
06
07
08
EMU - Real GDP
It is thought that this decoupling of growth rates is
not simply cyclical. The US slowdown could have
deeper origins in view of the imbalances that have
(Cont’d page 2)
Olivier Bizimana
Tél. +33 (0)1 43 23 67 55
[email protected]
Internet: http://www.credit-agricole.com - Economic Research
Olivier Bizimana
Tél. +33 (0)1 43 23 67 55
[email protected]
accumulated over the past decade: the property
bubble, swelling household debt levels, the current
account deficit, etc., come to mind. As a result, US
growth potential may be reduced. This is today
estimated at 2.5-3%, compared with 3-3.5% in the
middle of the present decade. In the eurozone, we
have long tended to underestimate growth potential,
highlighting structural handicaps such as the
unfinished liberalisation of goods and labour markets
and unfavourable demographics. But these estimates
have finally stabilised, with growth potential now
estimated at around 2-2.25%. Stabilisation on the
one hand and reduction on the other mean that the
trend growth differential has narrowed by 0.75 of a
percentage point.
European stock markets outperform
These cyclical divergences between the United
States and Europe can also be seen in share price
trends.
Over the past two years, European stock markets
performed better than US markets. The Eurostoxx
index rose by nearly 60% between end-2005 and
end-2007, whereas the S&P 500 advanced by only
16% over the same period. With hindsight, these
trends are also of a nature to justify the euro's rise
against the dollar, at least until the end of 2007.
Since the start of 2008, European stock markets
have, it is true, seen a more marked correction, but
in trend terms their gains are still higher than those
of US stock markets.
Asymmetric monetary policies
US-EMU: Equity markets
Economic divergence has resulted in differing
monetary policy stances.
The cyclical divergence between Europe and the
United States has naturally led to asymmetrical
monetary policy responses. European economic
recovery since end-2005 has allowed the European
Central Bank to embark on a process of interest rate
normalisation, with a high point of 4% in June 2007.
The ECB's systematically forceful discourse with
respect to inflationary risk had nurtured expectations
of rate hikes, at least until the start of 2008. In the
United States, however, faced with the threat to
growth represented by the property recession, the
Fed maintained a prudent stand by holding rates
steady between August 2006 and September 2007.
Market expectations began to price in rate cuts from
early 2006, but it was not until the summer's
financial crisis was triggered that the Fed acted, with
an initial 50bp cut on 18 September 2007. Since
then the Fed has pursued an aggressive policy of rate
cuts, taking the Fed Funds rate down to 3% in
January. The markets are assuming that the process
will continue, discounting further cuts of 50-100 bp
during 2008. Growth is also set to slow in Europe,
and the ECB should eventually concede more rate
cuts: that, in substance at least, is what the markets
are expecting. But both overall and in trend terms,
the forecast interest rate differentials are favourable
to the euro.
200
bp
Euro-dollar and forward interest rate differential
euro/usd
1,52
150
1,48
170
160
150
140
130
120
110
100
90
Jan-05
thousands
contracts
0
1,24
-25
-150
1,2
-50
-200
Jan-05
1,16
Jan-08
euro/dollar (rhs)
EUR
(thousands of contracts net balance)
1,30
75
1,32
Jul-07
Speculative positions on the EURO
1,40
25
Jan-07
Euro Stoxx
100
1,36
Jul-06
S&P 500
Jan-08
1,50
0
Jan-06
Jul-07
125
50
Jul-05
Jan-07
150
1,4
Forward interest rate differential(EMU-US)
Jul-06
Furthermore, the euro's appreciation has, it would
seem, been fuelled by high levels of optimism about
the single currency, which from time to time may
have taken hold of the markets against a backdrop
of improved activity prospects in the eurozone. As
shown by the chart below, net long speculative
positions on the euro have been rising since early
2006. The euro may also have played a
diversification role for some investors overexposed
to dollar risk.
1,44
-100
Jan-06
"Euro plays"!
50
1,28
Jul-05
Source : Datastream, CA
100
-50
100 = 2005
1,20
1,10
1,00
0,90
0,80
99
00
01
02
03
net balance
Source : CME, Bloomberg, CA
04
05
06
07
08
EUR/$ (rhs)
Source : Bloomberg,, CA
No. 88 – February 19, 2008
2
Olivier Bizimana
Tél. +33 (0)1 43 23 67 55
[email protected]
Long-term fundamentals
Capital flows: improvement in the bilateral basic
balance
The bilateral basic balance (ie, current account and
capital account + long-term financial flows: foreign
direct and portfolio investment) between the United
States and the eurozone has, since 2006, improved
sharply in favour of the euro. The bilateral basic
balance alone suggests a euro/dollar exchange rate
of around 1.40 at end-2007. The improvement in
the bilateral basic balance is mainly due to capital
flows, the trade balance having been relatively stable
and in positive territory. Eurozone investors have cut
back on their purchases of US assets. Purchases of
European securities (bonds and equities) by US
residents have, on the other hand, picked up
sharply. Furthermore, net FDI flows have largely
benefited the eurozone.
US- EMU Bilateral Basic Balance
(Net flows cumuled over 4 quarters)
inv.sc.; bln usd
-250
euro/usd
-200
1,3
-100
-50
1,2
0
1,1
50
1
100
0,9
150
200
0,8
99
00
01
02
03
04
05
06
07
Basic balance: current account + capital account
+FDI+portfolio investments (inv.sc.)
euro/usd (rhs)
Source : Datastream,CA
Long-term models: PPP points to a euro/dollar rate of
around 1.15-1.20
One method that is often used to calculate the longterm equilibrium level of the euro exchange rate is
purchasing power parity (PPP)1. Under this approach,
the equilibrium level for the euro is in a range
1.15-1.20 to the dollar.
Euro/dollar: nominal exchange rate and PPP
1 euro = ...usd
1,6
Mid-long term: our macroeconomic models justify a
euro/dollar rate of around 1.30.
In view of the shortcomings of the PPP method, we
have calculated econometric models using a number
of macroeconomic variables that influence exchange
rates, such as productivity gaps, net external
positions, terms of trade and public consumption
gaps in order to determine a euro/dollar equilibrium
rate.
1,5
1,4
Lagged 2 quarters
-150
that since the 1980s, the euro/dollar exchange rate has,
on average, fluctuated within a band of +/- 20%
around this target value. When the exchange rate is
well outside this zone, which has not actually
happened very often, centripetal forces kick in to bring
it back inside the band within three or four quarters.
On the strength of these observations, because the
euro has been outside the upper level since the start of
the second half of 2007, we could possibly see a
return towards a range of 1.38-1.44 by the end of
Q1 2008.
Introduction of the euro
After testing several combinations of variables, we
chose the most relevant, which takes sectorial
productivity gaps and net external positions into
account, as follows:
ƒ All else being equal, a lasting improvement of
1% in eurozone productivity leads to a real appreciation in the euro of around 2% against the dollar;
ƒ A deterioration in Europe's net external position
of 1% of GDP implies, over the long term, a real
depreciation in the euro of around 0.02% against
the dollar;
The chart below shows the euro exchange rate and
its equilibrium rate on the basis of the fundamentals taken into account. Note that the longterm equation satisfactorily explains euro/dollar
exchange rate trends in the past 30 years2. Over
the recent period, our long-term equation only
accounts for part of the euro's appreciation. The
model suggests a euro/dollar equilibrium level of
around 1.25 – 1.30.
1,5
1,4
Euro/dollar: Equilibrium exchange rate
(variables: productivity differential and net external positions)
1,3
1,2
1,6
1,5
1,4
1,3
1,2
1,1
1,0
0,9
0,8
0,7
0,6
1,1
1,0
0,9
0,8
0,7
0,6
81
83
85
87
89
91
93
95
Euro/usd
Source : Datastream,CA
97
99
01
03
05
07
Euro/usd PPP
1 euro = ...usd
81
+/- 20 %
83
85
Introduction of the euro
87
Source : Datastream,CA
This approach is anything but satisfactory to evaluate
short-term variations in exchange rates. Deviations
from the equilibrium level tend to be persistent (on
average around 5-6 years). One can observe, however,
1
At equilibrium, the nominal exchange rate should offset
differences in inflation.
No. 88 – February 19, 2008
89
91
93
95
97
99
01
03
05
07
Euro/usd
Euro/usd Equilibrium exchange rate
2
The estimate of the medium term model is based on the real
exchange rate. The chart shows a simulation of the equilibrium
model (by level, with the variables smoothed using an HP filter).
The variables have been converted into nominal terms in order to
make them easier to understand.
3
Olivier Bizimana
Tél. +33 (0)1 43 23 67 55
[email protected]
Conclusion and outlook
Several factors have contributed to the euro's
appreciation against the dollar:
1) Divergences between activity cycles in the
United States and the eurozone, which have
resulted in differences in monetary policy and
stock market performance;
2) Excessive market pessimism about the US economy and the dollar;
3) A slight structural improvement in European
fundamentals (basic balance and productivity);
Changes in the euro/dollar exchange rate over the
coming quarters will depend on a number of factors,
including:
1) In the short-term, as long as the slowdown
remains centred on the United States and does
not spread to the rest of the world, and to
Europe in particular, the euro/dollar exchange
rate should remain high;
2) Because economic activity is set to flag in the
eurozone, the euro's support factors will progressively erode (due to the narrowing of growth
differentials and interest rates in particular),
probably causing the euro to depreciate;
3) Going beyond the short-term, according to our
model, the equilibrium bilateral parity should be
around 1.25-1.30. The rate is therefore likely to
trend towards that level, but the pace at which it
will do will depend partly on how fast the US
economy recovers. „
Crédit Agricole S.A. — Economic Research Department
75710 PARIS Cedex 15 — Fax: +33 1 43 23 58 60
Chief Editor: Jean-Paul Betbèze
Contact: [email protected]
Website: http://www.credit-agricole.com - Economic Research
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No. 88 – February 19, 2008
4