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The USD / EUR Pair and Its Recent Development


John Hjorth
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This topic is most likely especially for European CoBF investors, but please all, feel free to chim in.

 

Some links:

 

XE Currency Chart: USD to EUR - 2 years.

XE Currency Chart: USD to EUR - 10 years.

 

From the "2017 Results" topic, it seems like an ongoing theme for European CoBF investors invested in the US, that they have all been hit in 2017 by the development in this currency pair since December 2016. Several European fellow board members have mentioned it in the topic, including myself.

 

The last few days, I've been thinking about what it's about, for some judgement about it going forward, and honestly, I'm not able to comprehend this in the rear mirror, and thereby not able to come even close to a forward judgement or opinion on this going forward.

 

- - - o 0 o - - -

 

Any input very much appreciated.

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The divergence of the currency pair vs the PPP index was very high during 2016 and early 2017 and sooner or later that gap needed to close at least a bit.

 

I personally don't ever worry about currencies as a European investor. Currently I hold stocks in Canada, USA, Hong Kong, Australia and Europe. If I'm not mistaken, over very long time periods the impact of currency fluctuations on results is minimal. In any case I simply think it is good diversification too.

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I find currency is probably the area where I have the weakest understanding/sophistication. As a general rule I try not to make it too big a factor in my investment decision. I think the country you live in is a factor; I live in Canada and tend to invest mostly in the US.

 

Watching TV and listening to all the ‘experts’ what I hear is many are waiting for the ECB to get more aggressive with slowing its purchases of bonds and to eventually actually start to raise rates so in the coming years 10 year bond yields in Europe will move much closer to those in the US; so the expectation of this will result in a higher Euro over time. It sounds like the currency markets are forward looking; the rates you see today reflect what people expect to happen down the road.

 

If you look at current 10 year bond yields in Germany and the US you would expect money to be flowing to the US for the much higher yield and for the US currency to be appreciating (please correct me if my logic is wrong). This is not happening.

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Thanks for sharing, Viking & SharperDingaan,

 

Bloomberg: Trump Team at Davos Backs Weaker Dollar, Sharpens Trade War Talk [2018.01.24].

 

Bloomberg Gadfly: Let's See How Mario Draghi Digs Himself Out of This Hole [2017.01.22]. You can read the full article by clicking on the article link in this Bloomberg tweet.

 

Based on what Viking posted above, combined with the content of these articles, the culprit seems to be on this side of the Atlantic Ocean right now. A market nervous about what ECB will do going forward. A bit like in the US pre FED started the interest rate hikes.

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I find currency is probably the area where I have the weakest understanding/sophistication. As a general rule I try not to make it too big a factor in my investment decision. I think the country you live in is a factor; I live in Canada and tend to invest mostly in the US.

 

Watching TV and listening to all the ‘experts’ what I hear is many are waiting for the ECB to get more aggressive with slowing its purchases of bonds and to eventually actually start to raise rates so in the coming years 10 year bond yields in Europe will move much closer to those in the US; so the expectation of this will result in a higher Euro over time. It sounds like the currency markets are forward looking; the rates you see today reflect what people expect to happen down the road.

 

If you look at current 10 year bond yields in Germany and the US you would expect money to be flowing to the US for the much higher yield and for the US currency to be appreciating (please correct me if my logic is wrong). This is not happening.

Currencies are notoriously hard to price and I don't think anyone really can price them precisely. You have certain frameworks like PPP but it's a loose science. It's not like you can do a DCF. Euro is even harder cause you have all these different countries with their own bonds and fiscal policy rolled up into a currency.

 

In regards to your logic on money flows, yes it has some laws in the sense that money doesn't flow as much as you think. Money tends to stay put. Let's say that I'm a German that likes those fat Treasury yields. So I sell my Bunds and go for Treasuries. But first I must exchange my euros for US dollars because Treasuries are USD denominated. Normally you get USD from an American so I do that, I get my Treasuries and I'm one happy Kraut. BUT... now some Yank has my Euros. They're actually pretty useless in his hand. He basically has 3 options: 1. Buy German bonds, 2. Buy a German export, 3. Economic investment - build a factory in Germany.

 

As you can see in all 3 of those scenarios the money comes back to Germany - it actually doesn't really leave.  Capital (ownership of stuff) has some flows and that is dictated by economic investment and trade which then influence interest and exchange rates not the other way around. I hope this makes sense.

 

Now in the European union money can actually flow because they have the same currency. This causes German bonds to carry a safety premium. Say that I'm a Greek with savings. It's not very smart for me to keep those savings in Greek bonds or CDs because they're basically all crap and I may not get my money back. But it's really easy for me to buy Bunds because they're denominated in Euro and my savings are in Euro. This bids up the demand for Bunds and results in low yields. Btw this doesn't apply only to Germany but to other safe countries: France, Netherlands and the 2 Scandinavian that use Euros: Finland and Denmark. All have low yields.

 

Edit: I took out something stupid I said about capital flows. German capital is going to the US because Germany has a trade surplus with the US.

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Looks like the big mac index says euro is still slightly undervalued.

 

http://www.economist.com/content/big-mac-index

 

randomep,

 

You really made my day with this.

 

...Burgernomics was never intended as a precise gauge of currency misalignment, merely a tool to make exchange-rate theory more digestible....

 

Just hilarious! [ : - ) ]

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Yep! :) . One area I fully agree with Trump. I want to see a strong dollar  ;D

 

I certainly agree with this. However, I have to say, that this phenomen going on right now is like looking through the PlexiGlass lid of our Miehle washing machine while in operation, in stead of my monitors. I mean, there are similarities.

 

The problem here is, that I don't know if this description fits being inside the washing machine looking out, or being outside the washing machine looking in.

 

In the short run & looking in the rear mirror short term, it looks like I'm ouside the washing machine, ref. tom earlier. Very stressful, however.

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If someone wants to understand currencies i can recommend the currency article series from Ruerd Heeg on Seeking Alpha. https://seekingalpha.com/article/4139335-best-currency-positions-february-2018

 

In general i think you want to be in a currency where short term interest rates are higher than inflation (and 10y bonds are a good proxy for that) and that is undervalued on relative purchasing power. That way the purchasing power of your money is maximized.

Ideally the interest rate in the country you want to invest in is higher than in the country from which you exchange, that way you also get paid for the exchange so you have a positive carry.

And of course despite the fundamental side, momentum also works but the effect fades after 12-15 months.

 

At the moment the mexican peso is the best currency to be in, and the € momentum is already starting to fade. Going forward i don`t think the € is a good currency to be in, even if slightly undervalued against the dollar, because the spread between interest rates and inflation is pretty high, you are losing roughly 1.7% every year to inflation and the central bank is far from closing that gap. In the USD you are losing just 0.9% and the central is on the run to close that gap this year.  The USD is now in the middle of the pack fundamentally, but the worst by momentum so it is not the best currency to be in, too.

 

 

And btw. i think currencies are just a big hassle, they only add volatility and frustration if unmanaged and hedging is very cheap in the form of futures. So not doing it and finding pseudo arguments like "they even out over the long term" is just an excuse for being lazy! :)

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Thank you frommi!

 

I just started following Mr. Heeg on SA. His stuff makes sense to me.

 

... The USD is now in the middle of the pack fundamentally, but the worst by momentum so it is not the best currency to be in, too. ...

 

I'm just trying to understand your use of terminology here. With regard to "momentum", are you here referring to the short term movements/trends in the market of the USD / XXX pair, so "momentum" here is related to sentiment to some extent?

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I'm just trying to understand your use of terminology here. With regard to "momentum", are you here referring to the short term movements/trends in the market of the USD / XXX pair, so "momentum" here is related to sentiment to some extent?

 

I measure 1, 3 and 6 months return of each currency against the USD and then create a rank for each currency. So its just the past price movement.

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  • 2 weeks later...

I think fundamentally it looks like that:

 

In an environment of increasing interest rates states like Greece, Italy etc. can not stand higher interest on their bonds. So the ECB is destinated to keep on buying or even extending the buying of gov bonds.

 

In US the interest rates for T-Bills will rise and the widening spread will lead to a stronger USD against EUR.

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