Basic economic theory states ceteris paribus — “all else being equal” — meaning the higher yielding a currency in real terms, the stronger the exchange rate should be against a lower yielding currency. There are, of course, many other factors that affect the exchange rate, but yield is certainly toward the top of the list.
And lately, the euro has been going up on expectations of European Central Bank (ECB) rate hikes in the next couple of years, while the interest rate outlook in the United States is still uncertain.
I think those coming ECB rate hikes will backfire because of the fundamental disconnect between different countries with divergent monetary policy needs, and single currency being exacerbated by the rate hikes. For example, Spain needs interest rate cuts, while Germany probably needs the hikes.
In a strange way, consumer price inflation is higher in Spain than it is in Germany — the CPI year-over-year change is 3.6% in Spain, while in Germany, it’s a hair above 2%. Keep in mind that it is always a little bit of an apples to oranges comparison when it comes to the CPI indexes of two different countries as they often have rather divergent weightings of the same components. But the Spanish economy is clearly weaker while Germany’s is firing on all cylinders. Spain has floating-rate mortgages, which will get progressively more expensive, and a weak real estate market that will get progressively weaker. This is not going to be good news for Spanish banks as the year progresses.
As we watched Portugal behave in a manner similar to Greece, denying the need for a bailout until the very last minute, I wonder if Spain will do the same. With a GDP that is double the sum of the three smallest PIIGS combined, the Spanish economy likely holds the key to the euro crisis, which is far from over despite the rallying euro.
How to Play the Coming Collapse
I have previously indicated my recommendation to stay away from European financials because the sovereign bonds they are saddled with have not been properly marked down, so likely hits to their book values are coming. While no skeletons have been brought out of the closet yet, Deutsche Bank (NYSE: DB), Santander (NYSE: STD) and BBVA (NYSE: BBVA) have notably underperformed the U.S. financial sector, with two very large and tradable sell-offs in the past year. I still believe that rallies in those stocks are rallies to sell as the European situation is far from being resolved.
I thought that the euro will have difficulty staying above $1.40 against the U.S. dollar, but so far this has turned out not to be the case. I would not aggressively try to short it here, but I would not be a buyer either on the fundamental view that it is overvalued.
It has been somewhat surreal to see the euro rally on the same type of news flow that caused it to drop rather dramatically in 2010, but QE2 and other Fed actions might be to blame for that — it is not just the ECB that determines the fate of the exchange rate.