Euro Traders: Is the Euro Undervalued?

06/09/2010 9:29 am EST

Focus: FOREX

Kathy Lien

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

Since the beginning of the year, the euro lost more than 16% of its value against the US dollar. The European sovereign debt crisis turned investors against the regional currency and prevented it from enjoying even a single positive month since January. With the EUR/USD trading comfortably below the 1.20 level, the question burning in the minds of all euro traders is how much further can it fall? In this morning’s intraday note, we talked about the key support levels in the currency, and the closest point is the 2005 low of 1.1640.

The decline in the EUR/USD has also raised the question of whether the currency is undervalued, and based upon purchasing power parity (PPP), the answer is no. The following chart shows how even the most conservative estimate by the Organisation for Economic Cooperation (OECD) has the EUR/USD overvalued by 2%. According to Bloomberg’s calculation of PPP using consumer prices, the euro is 6% overvalued against the US dollar. The reason why the PPP values are not consistent is because different methods of calculation and different baskets of goods used to compare prices will arrive at different PPP rates.

Purchasing power parity may have its flaws, but it is here to provide traders with a reference point for valuation at a time when a currency pair has become deeply oversold. At the same time, European policymakers have failed to calm investors, and for the time being, are still sitting on their hands. New details could be announced at the meeting between euro zone finance ministers, but we expect the ECB to keep monetary policy easy on Thursday. Therefore, from a fundamental, technical, and valuation perspective, the EUR/USD could still head lower.

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By Kathy Lien, analyst and blogger,

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