A big caution flag should accompany currency traders' apparently overwhelming bets that the euro will lose ground against the dollar as a result of an expected widening of interest rate differentials favoring greenback-denominated assets.
The yield gap along the entire term structure may indeed open up, but more substantive investment arguments have to be considered in the context of capital flows into bond and equity markets. And that is where the dollar-euro story transcends the simplicity of yield differentials.
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America's bond prices have been declining for the last two years, despite the fact that, over that period, the U.S. Federal Reserve (Fed) bought more than $1 trillion worth of Treasury securities to keep long-term interest rates down. The most recent events suggest that this trend is very likely to continue as a result of the strengthening cyclical upturn in the United States, the Fed's announced withdrawal of monthly asset purchases and the ensuing increase of short-term interest rates.
In view of that, it seems that the probability is very low for any substantive capital inflows into U.S. fixed-income markets over the next twelve months.
The outlook for further price gains in U.S. equity markets appears to be less problematic. There are, however, a number of reasons why a sustainable increase in already record-high stock price indexes may not be as easy as the dollar bulls seem to think. Their scenario would have to be underpinned by (i) a continuation of the Fed's hugely expansionary monetary policy, (ii) strongly advancing aggregate demand, (iii) accelerating profit growth and (iv) tame unit labor costs.
How likely are these events?
As always, the degree and the timing of the Fed's incipient policy change will depend on the state of the economy and on the medium-term outlook for price stability. Anticipating stronger economic activity, the Fed seems ready to moderate, and subsequently tighten, its unsustainably loose credit stance. The belief that the Fed will continue on its present course implies that the U.S. economy is terminally stuck in a stagnating growth pattern, aggravated by declining costs and prices.
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But that is not what the dollar bulls (and euro bears) are seeing. Their current forecast of the dollar's exchange rate rising to $1.24 per euro (from $1.36 at the moment) by the end of this year assumes a strengthening U.S. economy, the Fed's tightening policy, virtually no growth in the euro area and a further credit easing by the European Central Bank (ECB).
Think again before selling the euro short
I agree with the relatively upbeat view of the U.S. economy and the expectation of the Fed's gradually less accommodative monetary policies. But I beg to differ about the euro pessimism for the following reasons.
The euro bears may wish to consider the stimulus of the ECB's exceptionally easy credit stance working in tandem with a significant slowdown of fiscal consolidation in all major euro area economies. That policy mix has been at work for all of last year and is the main reason why the monetary union began to emerge from its debilitating recession.
Even Greece is making a heroic promise that it will soon begin paying its own way, with some economic growth later this year. Spain's devastated labor markets are improving, and the country needs no further help with its bank restructurings. Portugal came out of a recession in the third quarter of last year, and it may no longer need conditional lending from the IMF and the EU. The house building in Dublin has picked up in recent months as the clobbered Celtic Tiger exults about making "a clean exit" from the bailout program …
A very modest progress, no doubt, but these were all of the eurozone's major disaster areas. And they are all beating German Chancellor Merkel's forecast. Reflecting her deep concern about the euro area, she told the regional meeting of her Christian Democrats (CDU) party on November 3, 2012 that "we need a long breath of five years and more" to get out of the financial crisis.
Still, even if the crisis is over, it is much too early to celebrate because 19.3 million people in the euro area have no jobs and basic welfare services.
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But a silver lining of this crisis – if there are any – is that the increasing labor mobility is helping to alleviate some of these problems.
It is not just that the Portuguese are migrating to Angola and Mozambique, and that the Irish are back on their traditional immigration trails to the U.S. and Canada. They are also finding jobs in Europe. It has almost become fashionable for young French graduates to work in other EU countries. And the number of German workers and students moving to Austria has doubled in the last six years.
These intra-European migration trends are bound to amplify. Despite the Bavarian political football with alleged abuses of "immigration tourists" from Bulgaria and Romania, the German Chamber of Commerce and Industry, and the German government, are welcoming the labor force from their European neighbors. They estimate that Germany will need "at least 1.5 million immigrants" in the coming years to help keep the economy going and to pay for the country's social welfare system.
Strengthening the euro area's management
Increased labor mobility is an encouraging sign because it is one of the key conditions for the monetary union to operate as an optimum currency area. That is also an indication that a broad range of administrative reforms to create a more integrated EU labor market are working.
The completion of the banking union is another milestone for the euro area. That will now be complemented by the forthcoming French-German initiative – tabled for late May/early June – to strengthen the area's national budgetary management as a stepping stone to a cohesive and disciplined fiscal union.
Investors have to realize that the euro area is a very difficult work in progress – a unique example of nation states and erstwhile bitter enemies agreeing to share sovereignty in order to create a united continent of peace, democracy and prosperity. They have already achieved the longest period of peace in the continent's history, no mean feat to remember in the year commemorating the WWI's European theatre as the greatest butchery the humankind has ever known.
And despite all the hardships of the financial crisis, the euro area – just joined by Latvia as the 18th member country – showed the political resolve to stick together and continue to build Europe's new economic, social and political architecture.
Here is what investors should expect: the fiscal consolidation, price stability, early stages of the recovery and ample liquidity will keep downward pressure on euro area bond yields. Equity markets in the euro area will benefit from supportive monetary policies and rising profits sustained by the increasing output, subdued wages and cyclically-induced productivity gains.
Dollar bulls would do well to remember that the love of the greenback does not imply unreasonably pessimistic euro bets.
Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.
Follow the author on Twitter @msiglobal9