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Pimco: The Euro Tug-of-War

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The eurozone could end up with problems similar to Japan's: a too-strong, overvalued exchange rate, weak growth, very low overall inflation, and deflationary tendencies.

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Discussions on currencies usually end up being very messy. Ask three different people about the future direction of a particular currency and you are likely to get three different opinions.

Take the discussion on the future direction of the euro. On one side, the current broad consensus -- a rather unusual phenomenon in itself -- among foreign currency professionals and economists concludes that the euro is likely to weaken in the months and years ahead. Plagued with economic stagnation, record unemployment levels, little fiscal room to maneuver and little political will to support necessary structural changes to achieve a more comprehensive banking and closer fiscal union, the direction of the euro against its major trading partners appears to be straightforward.

Yet, some encouraging developments in the region's economic fundamentals appear to hint at just the opposite: The meaningful improvement of the eurozone's current account balance, rising net capital inflows, and GDP growth pleasantly surprising to the upside in the second quarter all point to an increasing probability that the euro will continue to stay strong in the weeks and months ahead. Without a clearly defined roadmap to point the way, where does this leave investors?

A case for depreciation

There are powerful arguments for why the common currency should trade weaker. First, the eurozone economy is still the weakest major global economy. We expect the region to continue to barely grow over the next three to five years, given the mix of fiscal austerity, broader structural reforms and private sector deleveraging the region has prescribed itself. Second, the eurozone crisis is not necessarily solved. As long as it is not 100% clear that the currency union in Europe is irrevocable, investors cannot be sure that, for example, a "Greek euro" will be worth as much as a "German euro" in the future. The unprecedented introduction of capital controls in Cyprus in March this year proved to every investor how relevant this seemingly theoretical issue has become.

It is therefore only rational to expect investors will require an additional political/institutional risk premium for holding the common European currency. The existence of such a risk premium is a new feature for a developed market currency.

Introducing political/institutional risk factors into the euro equation

For investors in emerging markets, the analysis of such risks factors has always been an important part of the daily assessment that informs their investment decisions. We believe one consequence of the New Normal investment environment is that the top-down approaches currently in use to analyze developed market currencies will have to merge to a rising degree with the more bottom-up-oriented emerging market currency analysis. For investors, this means they have to be aware that the true fundamental fair value of the euro may actually be lower than the number that traditional purchasing-power-based analysis suggests.

This brings us to the third argument for a weaker euro. Even traditional "old normal" purchasing power analysis show that the euro does not trade "cheap", but is still rather expensive. Taking the International Monetary Fund (IMF) fair value measure as an example, the euro is roughly 10% overvalued compared with the U.S. dollar (based on IMF World Economic Outlook as of April 2013), while others, employing a trade-weighted currency analysis, estimate it is 6% overvalued (as of 1 August 2013).

These overvaluations, however, are hard to reconcile with the ongoing weak cyclical position of the eurozone and its inherent political and institutional risks. But what an irony, if these exact factors, which require a weaker exchange rate as a necessary countercyclical stimulus measure for the ailing eurozone economy, would be a key reason behind the current euro strength?
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