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Column: Don't expect the euro's rally to last

By Anatole Kaletsky

What is happening to the euro? Currencies are more important than stock market prices or bond yields for many businesses and investors, not to mention for globe-trotting families and humble tourists. Which makes it surprising that so little attention has recently been devoted to the strengthening of the euro, which hit its highest level since 2011 this Monday, having jumped by 5.5 percent since September and over 8 percent since early July. This remarkable ascent, which has also driven the euro to its highest level against the yen since the 2008-09 financial crisis, means that European exporters are losing competitiveness, Americans and Asians who live or travel in Europe are feeling like poor relations and many economists are starting to worry that Europe's nascent economic recovery will be snuffed out.

Purely financial players, by contrast, seem to be more enthusiastic about the euro's strength than they have been for years. Speculative futures bets in favor of further euro appreciation have reached their highest level since the summer of 2011 — and the only time they were higher than that in the past decade was in the period just before the Lehman shock. Significantly, both of these speculative crescendos were followed by sharp euro declines, since currency markets generally turn when bullish sentiment reaches extreme levels. But there is a deeper reason to expect the euro's seemingly irresistible rise to reverse.

Currencies tend to move in trends for many years, and the fact is that the euro's long-term trend against the dollar is still almost certainly downwards, despite the big gains of the past few months.

The euro's long-run trend against the dollar turned down decisively more than five years ago. Since the euro hit an all-time peak of $1.60 in April 2008 it has moved in several cycles, making lower highs and lower lows. The previous peak before this week's was in April 2011 at $1.48 and the one before that was in November 2009 at $1.52. The subsequent lows, in June 2010 and July 2012, were both around $1.20. It seems reasonable to expect this level to be tested again in the next year or so.

The direction of the dollar's long-term trend against the euro (and before that the deutsche mark) has always been determined mostly by events in America, rather than Europe. The dollar rose strongly from 1980 to 1985, driven by the surging confidence in U.S. geopolitical power and economic revival under Ronald Reagan. The dollar then fell even more sharply from 1985 to 1991, as Presidents Reagan and then Bush consciously pursued a policy of dollar devaluation. After trading sideways until 1995, the dollar then appreciated strongly again until 2001 as the U.S. enjoyed the extraordinary economic growth and fiscal improvement under President Clinton, with the federal budget deficits completely eliminated for the first time. This trend reversed within weeks of President George W. Bush's election and the dollar declined almost monotonically from January 2001 until April 2008.

Throughout these decades, European events, even ones as spectacular as German reunification, the collapse of the Soviet Union and the creation of the euro, were never more than an obligato accompaniment to the main theme that seemed to determine long-term currency trends, which was the waxing and waning of global confidence in the U.S.

The key question for the euro now is whether this confidence will decay further or revive. Will U.S. growth accelerate, as most investors and the Fed are now expecting? And will Washington break out of budgetary gridlock, perhaps for the reasons described in this column in the past two weeks? If either or both of these things happen, then the euro's reversal could be quite abrupt.

If so, the many European economists, investors and businessmen worried about export competitiveness will be delighted. But they should be careful what they wish for. The strong euro has hurt European exporters, but it has been unexpectedly helpful in stabilizing the macroeconomics of the euro zone.

From a purely economic standpoint, the strong euro has begun to rebalance Europe's economy from excessive reliance on exports, towards consumption-led growth. This rebalancing is healthy because Europe's trade surpluses have grown too large to be sustainable. They are also becoming unacceptable to trading partners, as evidenced by the unprecedented criticism leveled this week at German trade surpluses in the U.S. Treasury's quarterly currency manipulation report.

Secondly, the strong euro has produced a surprising political benefit by tilting the balance of policy debate in Europe away from austerity, towards monetary and fiscal expansion. Until the summer, the German Bundesbank was fiercely attacking the European Central Bank (ECB) for supporting the Italian and Spanish bond markets and for extending easy credit to weak banks. But dire warnings about lax ECB policies debasing the euro have been hard to take seriously, even within Germany, while the euro is the world's strongest currency, rising not just against the dollar but also against the yen, the pound, the Swiss franc and the Chinese yuan.

Thus the euro's unexpected strength has turned the Bundesbank monetary hardliners into a European version of the Tea Party — a group of grumpy old men who harp on about irresponsible monetary and fiscal policies, but cannot seem to decide whether the imminent danger is inflation or deflation, banks that are too generous with credit or too stingy, a currency that is too weak or too strong.

As the Bundesbank and its austerian allies in Germany, Austria and Finland have been sidelined, France, Italy and Spain have been able to relax their fiscal austerity programs, allowing tentative economic recoveries to start. Meanwhile Mario Draghi, the ECB president, has gained the freedom really to do "whatever it takes" to preserve the euro, thereby restoring confidence to the bond markets and banking systems in Italy and Spain. So far so good, but what will happen if the euro reverts to a trend of long-term decline?

(Anatole Kaletsky is a Reuters columnist. Opinions are his own.)

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