Single currency's run of bad luck not over yet

ECONOMICS/Dan McLaughlin: It has been a bad summer for the euro, which has fallen on the foreign exchange markets against most of the world's major currencies, including sterling, the yen and the dollar.

I suspect the move has yet to run its course and, as a dollar bull, it would not surprise me to see the single currency trade back at parity against the US currency over the next few months, which would ease some of the fears currently expressed about Ireland's competitiveness.

The euro's weakness has also caught most analysts by surprise, as the consensus had been looking for the single currency to strengthen through 2003, with many forecasting rates of $1.25 or above by year-end.

As such, the setback for the euro has prompted a serious rethink by investors and traders, not only on likely FX trends but also on the speed and scale of the global economic recovery.

The euro bottomed out against the dollar as long ago as autumn 2000, trading at $0.823, but its advance only began to gain momentum in 2002, and it traded above parity that summer.

In 2003, in the late spring there were further sharp gains against the dollar, leading to a high of $1.1933 in late May.

Explanations vary as to the cause of the rally but it does seem clear that the global downturn played a part because it resulted in a pronounced shift in the composition and direction of global capital flows.

In the heady days of the 1990s, cross-border flows into equities soared, as did foreign direct investment.

In that environment, economic growth matters, with the stronger economies such as the US attracting the most flows and hence emerging with the strongest currencies.

So the dollar ruled the roost in the second half of the decade and the single currency suffered from the perception that the euro-zone economy could at best grow by 2.5 per cent in the medium term, which looked limp against America's potential growth rate of 3.5-4 per cent.

The US recession in 2001 changed this, as did the muted nature of the recovery. Investors became risk averse, particularly after three successive years of falling stock markets, and global equity flows suffered at the expense of global bond flows.

Investors began to put cash into those economies with the highest interest rates, be it short-term rates or 10-year bond yields.

The euro zone scored highly here on both counts - the ECB repo rate of 2 per cent compared very favourably with the 1 per cent official central bank rate in the US, and by mid-June this year 10-year yields in the States had fallen to 3.1 per cent, against 3.5 per cent and above on offer in Europe.

The euro's interest rate advantage was even more pronounced for Japanese investors who, by May, were receiving less than half a per cent on 10-year bonds. The result was a substantial inflow into euro-zone fixed income assets, with Japanese investors leading the charge, which propelled the euro up and the dollar down over the first half of 2003.

I argued earlier in the year that a US-led economic recovery would benefit the dollar at the expense of the euro, on the basis that such bond flows would give way to renewed interest in equities, and that the euro-zone's sluggish economic performance would again be seen as a negative for the currency.

Certainly the last two months have seen massive selling of European bonds, again led by the Japanese, and this is the prime factor behind the euro's fall.

The immediate catalyst for the about-turn in Japanese flows was a sharp rise in bond yields in Tokyo 10-year yields that are now above 1.6 per cent but the underlying factor at work is a marked change in market sentiment about the global economy.

We now know that the US economy grew at an annualised rate of 3.1 per cent in the second quarter, and the data over the past few months have consistently surprised to the upside, to the extent that most analysts now expect growth in the third quarter to exceed 4.5 per cent, led by a sharp recovery in business spending on machinery and equipment.

The substantial rally in world equity markets since the spring is also testimony to the growing evidence that the recovery is real, even in Japan, where the economic data have also picked up. The upturn in Japan has also attracted substantial equity inflows, propelling the Nikkei up 25 per cent year to date and putting further pressure on the euro, this time against the yen.

Any recovery in the US and Japan is, of course, good news for the euro zone, and business confidence and sentiment has clearly turned for the better in recent months.

Yet unlike the other two major economic blocs, this improvement has yet to materialise in the hard data, so further dollar gains at the expense of the euro can be expected over the autumn. The next key level for the euro is $1.0520 and, if that goes, parity beckons.

Dr Dan McLaughlin is chief economist at Bank of Ireland