ALBANY, N.Y., May 27, 2003 (PRIMEZONE) -- The euro has dramatically risen against the USD because longer-term euro bonds are expected to experience an equivalent percentage price appreciation if widely expected Central Bank interest rate cuts materialize. If markets exhibit efficiency, currency values in the short-term must move so as to neutralize expected excess relative total asset returns among countries.
Current speculation about the causes of the euro's rise include more favorable interest rate differentials (European Central Bank benchmark rate of 2.5% vs. 1.25% US Fed Funds rate, for example), the US Balance of Payments deficit, and possibly an increasing use of the euro as a competing reserve and oil-trading currency. The first factor could account for only a small fraction of the euro's 10% 2003 rise, unless one wants to accumulate the differential rates unhedged for 10 years. No one has demonstrated and quantified the latter two factors. Quite simply, hedged expected asset price arbitrage is at work.
With Germany posting worse-than-expected negative first quarter GDP coupled with extremely low inflation, investors sense major rate cuts ahead. German 10-year Treasuries yield 3.75% vs. 3.35% US, with a much stronger economy and higher inflation. It takes little imagination to see them 100 basis points lower at 2.75% within a year, along with significant benchmark rate cuts. That equates to about a 9% increase in bond prices: about the same as the euro's rise.
If this theory is correct, the euro will stop rising after a possible further 5-10% appreciation (ironically appreciating more if growth is worse than expected), and will fall from such levels in the longer-term as the economic reality of a relatively faster growing US economy drives currency values. A rise in the dollar may come sooner if investors become convinced of recovery and therefore profit prospects driving the US stock market higher and sooner than EU equities. Then US assets will be expected to earn a greater relative return and the euro will be sold for the dollar.
Doubters should consider the relationship between the rise of the Yen vs. the USD during 1970 -- 1990 and relative real stock prices. Further note that the USD did not fall against the Canadian dollar when Canada's central bank raised rates; but as expectation grew about a rate cut. Efficient market theory and numerous empirical examples favor relative expected principal asset returns as the key determinants of currency values rather than balance of payments-related supply and demand or current yield differentials.