So in my last post, I left you with these increased risks of foreign exchange controls, imposition of restrictions on the flow of capital or on investment, possibly higher taxes on savings. And I was telling you that these risks cannot be ignored. It’s not so outlandish to think about them.
We’ve seen it in the past and we cannot exclude the same thing from coming back.
However one of the things to watch very carefully in this crisis as it unfolds is also the relationship between the euro and the US dollar. That relationship is crucial because for the past 60 years, it has been at the heart of trade flows and investment between North America and Europe. In fact, it is the unique and sole guiding star that all investment professionals have been watching extremely carefully for the last decades. It has always acted as a beacon for decision making between North America and Europe, and in fact the world.
As a preliminary and to get a better sense of our coming discussion, I invite you to do a very simple search on Google. Plug in the Euro US$ parity and click on the chart that Google will give you. If you had trouble with it and for the sake of saving you time, here the link to the chart we will be commenting on in the minutes to come, Click here . Make sure you ask for the maximum of history. The chart will show you a Euro / US$ chart that goes all the way back to 1982. You can look at the value of the Euro versus the US$ or the opposite. But for the sake of our discussion here, we will refer to the number of US$ there are per Euro. Just a little side note here; I will always refer to charts and data that are commonly available and easily accessible. You don’t need to subscribe to expensive services to get access to them.
Of course, the Euro was only launched at the beginning of the 2000’s. So the number that the chart shows you here is an extrapolation based on the conversion rate of each currency joining the Euro at the date of their membership. Once you know that, you can calculate the Euro going back as far as you can. Here, Google manages to pull a history as far back as 1982. For example, the German Mark was locked at 1.956 German Marks per Euro, the French Franc at 6.56 FRF per Euro, the Italian Lira at LIRA 1936.27 per Euro, and so on. You get the picture. So once you know that rate that was baked into the Euro, then you are able to extrapolate the Euro for as far as you can, and that’s how Google did it. Sorry for the technical side, but I thought you should know.
So that history since 1982 is good enough for us, because once you take a look at that chart, it will tell you a fascinating history, a history that will help you project what is most likely to happen in the months and years to come.
Take a look at it and what you will see is extremely instructive and likely to shed some light on what is to unfold in the near future.
You see, that relationship at that time was at the heart of the world economy. China was yet to implement its model and Asian tigers were barely starting to shake the world. Japan was already well established as a member of the G3, among the top three economies in the world, but its model was still strongly reliant on the other G7 members, the core of the world economy namely the US, Germany, France, the UK, Italy and Canada. In other words, the world’s center of gravity was still hovering somewhere around the North Atlantic ocean. That relationship between the US$ and the core currency of Europe, the German Mark, was the crucial anchor of the world, and everyone had to pay attention to that one. It was the backbone of the world. And it still is, even though we talked to you few days ago about the rising share and power of the BRICS.
So when the Federal Reserve of the US started to hike rates in the early 80’s, the world was shaking. First, back at the beginning of the 80’s, you had a situation almost similar to what we are witnessing now; high inflation with a federal reserve much more inclined to fight it at any cost. It was just doing what it was supposed to do. “You got to do what you got to do”, and that was Paul Volker’s motto back then. That’s a style and that’s what built the Federal Reserve credibility. That was an aura that magically started to hover above Paul Volker’s head, and it never left him. So it obviously contributed to the US$ renewed strength, and the US$ flew through the roof, literally, pushing the hypothetical Euro (the DEM then and all the other European currencies) to the abyss at US$ 0.5930 per €uro at the beginning of 1985. Or to put it differently, one US$ reached a peak of DEM 3.3002.
Keep that number in mind; DEM 3.30 !!!
So as that chart shows, that extreme strengthening of the US$ was becoming untenable for most of the European economies. Among themselves, it triggered intense dizzying gyrations within Europe that left every single European policy maker powerless and much more prone to irreparable decisions and mistakes. In the end, leaders of the G5 (France, Germany, US, UK and Japan) decided to gather and cap the extreme strength of the US$. In fact, the US currency had gained strength not just versus European currencies, but also versus the Japanese Yen (look at the chart here); between 1982 and 1985, the US$ versus the Japanese Yen was fluctuating within that intense range of Yen 230-266.
As a result, all these central banks joined forces to push the US$ back to more reasonable levels of US$1.17 -1.24 per €uro (DEM 1.67 – 1.58), and Yen 150 per US$. The move was led with such success that another agreement was needed to prevent the US$ to slide even further. So the G5 +1 (Italy) met again to sign the Louvre Accord. It was then stipulated that each country would pursue the necessary reforms in terms of public expenditures, trade imbalances and market liberalization. There is so much more to say about these two agreements (Plaza and Louvre), because they literally stand at the heart of the world order that was to unfold. Every observer looks at the fall of the Berlin Wall as a tipping point to what came afterwards, but the real harbinger of what was to follow really took root during these two agreements. But that’s the topic of another discussion and we’ll get back to it. In any case, the US$ stabilized and the G7 could find solace in the fact that the Eastern bloc was collapsing at the same time.
Global markets could then feel reassured that currencies would fluctuate within these newly found bands versus the US$. These narrow ranges and wider ranges were implicitly agreed and everyone was fine. When tensions were at the lowest and the economies were cruising smoothly, parities would settle within a narrow range that contributed to cement further confidence in the near to medium term. When tensions were rising against one side of the other, the currency parity would tend to move outside of that narrow range to more extreme limits. For the €uro/US$ parity, anything within US$ 1.05 – 1.22 (DEM 1.86 – 1.60 per US$) would act as a narrow range. For the Yen/US$ parity, that narrow range would be US$130-150. The red zone for both parities would be outside of those ranges.
In any case, for both parities, since the Louvre Accord, currency markets have been fluctuating within these outer and inner ranges, alternating against one or the other party.
And up to now, everyone appears to abide by these ranges, at least implicitly, even in the absence of an explicit statement from monetary authorities. Speculators and hedge fund managers have respected these lines that cannot be crossed.
At least, that’s an order that makes everyone comfortable, but for how long?
Because the questions that we must all ask ourselves as we stand today are the following;
- Now that the FED is engaged in a rate tightening campaign, will the ECB follow in lock step ?
- Which Central Bank is more likely to succeed in its fight against inflation ?
- What differential of growth can we expect over the longer run?
Needless to say that for the first question, we have to admit that the ECB cannot go as far as the FED, because of the internal chaos likely to emerge within the Euro area, especially from those countries that are the most highly indebted.
It follows that, for the second question, the FED will probably succeed with a softlanding, whereas the ECB could crush inflation, but at the cost of a crash landing. Now, it would be a total disaster if it crashed and inflation remained elevated nonetheless.
And finally, for the 3rd question, the differential of growth remains of course a lot more favorable to the US.
In other words, the €uro still has a lot more to go on the way South. Remember, it hit US$ 0.60 in the early 80’s and US$ 0.86 in the early 2000’s.
That’s what I wanted to share with you today. Let me know if you have questions and feel free to comment.