Yes the Euro Is Down, But Is It Cheap?

05/19/2010 12:01 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

For the first time in five trading days, the euro ended the NY trading session higher against the US dollar this past Monday (May 17). No major European data was released on Tuesday, but the weakness of the euro has started to stress policymakers. Over the past month, the euro has fallen more than 8%, or 1100 pips, to a four-year low of 1.2234.  Based upon the IMM positioning data from the CFTC and the Treasury International Capital report from the US, both private investors and traders have moved out of euro and into the safety of US dollars. One of the important questions that we were asked today is what investors have been doing and what they should do going forward. 

The price action clearly indicates that investors have been dumping euro, but the trade has also become extremely overcrowded, which means that the risk of a short squeeze is very high. The ECB has already released details on their bond purchase program and sterilization, which is encouraging, but unimpressive. So far, they have spent approximately EUR16.5 billion and will be sterilizing the same amount using one-week tenders. Given the massive size of reserves created by their regular unlimited tenders, sterilization of EUR16.5 billion is nothing more than a symbolic move to downplay significance of the operation. The ECB has stressed that their decision to buy government bonds did not equate to a return to quantitative easing (really a matter of semantics, in our opinion). 

Yesterday evening, the euro group has another opportunity to support the euro. Finance Ministers in the euro area are meeting in Brussels to discuss the market’s reaction to their rescue package, developments in Greece and Spain, and Portugal’s accelerated fiscal programs and the euro.  Luxembourg Prime Minister Junker said the euro will be “Intensively discussed by ministers,” and perhaps this is his way of warning us that the discussions could turn into action.  The only reason why the EUR/USD has stabilized today is because of the upcoming event risks, and more specifically, the possibility of another sensational announcement from European policymakers. Therefore, the answer to the second question of what investors should do going forward is to brace for a short squeeze. If policymakers decide to verbally or physically intervene in the euro, the currency could see an aggressive rally to the scale of a few hundred pips. However, currency intervention does not tackle the root of the problems, which is the ability of countries with bulging deficits to service their debt.

Is the Euro Cheap?

Another interesting question is whether the decline in the euro has made the currency cheap. From the perspective of purchasing power parity, the euro is still 9% overvalued against the US dollar and 10.5% overvalued against the British pound. This implies that the currency is far from cheap on a valuation basis, but considering that the euro was 25% overvalued against the dollar back in November, it has certainly come a long way.

However, valuation matters little on a short-term basis since currencies can be over- and undervalued for extended periods of time. From a fundamental basis, we have to recognize that the euro has not been sold because of current valuation fears, but because of growth prospects and concerns about the viability of the union as a whole, which could push the currency from over- to undervalued. In other words, the euro is not cheap from a valuation basis, and even if it was, it doesn’t really matter. 

Aside from the announcement by EU finance ministers, the ZEW survey of investor confidence, euro zone consumer prices, and the trade balance are also scheduled for release. Investor sentiment is expected to be negatively impacted by the sovereign debt crisis. If central banks like Russia have been dumping euro for dollars, then we suspect that others have been doing so as well.

By Kathy Lien of

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