EUR - USD

EUR - USD Currency analysis

13 July 2011

Eurozone debt crisis turning into a Hydra

In their efforts to contain the sovereign debt crisis, politicians in the EU probably currently feel a bit like Hercules doing battle against the Hydra, the nine-headed beast in Greek mythology: hardly is one head lopped off the monster, another two grow back to replace it. The first head was chopped off in May of last year when a EUR 110 bn rescue package was approved for Greece. In order to head off contagion to other member states with unsound public finances, EU policymakers quickly struck again, constructing a gigantic safety net for the EUR countries with a volume of EUR 750 bn, known as the European Financial Stability Facility (EFSF), which was designed to dispel any investor worries about a possible default by a member of the Eurozone. To no avail. In November 2010 and April 2011, Ireland and Portugal were the next two countries which were forced to admit that without the assistance of the EU and IMF they would no longer be able to meet their commitments. Hardly had these two countries activated the safety net and hopes emerged in the EU that the Hydra had finally been conquered, when the crisis flared again in Greece, dashing these hopes. From the early summer of 2011 it became increasingly clear that Greece would not be able to return to the capital markets in 2012, as originally planned, and that the funds from the first bail-out would already be used up by the beginning of next year. The only solution to prevent a default by Greece with unforeseeable consequences for the financial system in Europe was to come up with a second aid package.

Hercules battling against the Hydra, Hans Sebald Beham, 1545 Source: Wikipedia

US forecasts
current* EUR/USD USD 3m LIBOR USD 10y yield 1.406 0.25% 2.93% Sep-11 1.50 0.3% 3.3% Dec-11 1.45 0.4% 3.5% Jun-12 1.35 0.75% 0.9% 3.7% USD Fed Funds 0-0.25% 0-0.25% 0-0.25%

* as of 13 July, 09:30 a.m. CET Source: Thomson Reuters, Raiffeisen RESEARCH

EUR/USD: Roller-coaster ride

1.60
tucriah eceerG f o raef ;ya M n oisiced etar tseretni BCE egakcap dia hsirI r of sdn ob nb 5 RUE seussi yllufsseccus n oissimm oC UE trats deF eht yb gnisaE evitatitnauQ rehtruf n o sn oitalucepS eceerG yb dereggirt n oissucsid tbed tnemnrev og f o edacsaC

1.55 1.50 1.45 1.40 1.35 1.30

1.15 Jan-07 Sep-07

Source: Thomson Reuters, Raiffeisen RESEARCH

Analyst Jrg Angel, CIIA

joerg.angele@raiffeisenresearch.at

SFSE dleihs evitcet orp nb 057 RUE ev orppa F MI dna UE

1.20

SB M f o esahcrup nb 005 DSU secnu onna deF

1.25

May-08

Jan-09

Sep-09

May-10

EUR/USD

seirusaerT f o esahcrup nb 006 DSU secnu onna deF seirusaerT f o esahcrup nb 003 DSU secnu onna deF

Jan-11

Sep-11

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This seemingly never-ending story about sovereign debt in the Eurozone has had a severe impact on developments in the EUR/USD exchange rate in the last one and a half years. For example, the sharp appreciation of the euro triggered by the loose monetary policy of the US Fed at the end of 2009 came to an end with the outbreak of the sovereign debt crisis, which led to a plunge in the value of the euro in the period up to early summer 2010. Since then, the euro has recovered significantly, despite the markets lingering worries about Eurozone public finances. Actually, taking into consideration the massive increase in risk premiums on government bonds issued by Greece, Portugal and Ireland and the steady flow of bad news about the sovereign debt crisis, this rebound by the euro was quite surprising. Clearly it is not the case that investors are avoiding the euro and see it as being particularly risky. One explanation for the apparent strength of the euro becomes obvious when looking at the development of fundamental conditions: one can see that since mid-2010 the exchange rate has been driven by the divergent economic development in the USA and the Eurozone, and especially by the interest rate differential between these two currency areas.

Interest rate differential drives EUR/USD

1.55 1.50 1.45 1.40 1.35 1.30 1.25 1.20 1.15 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 1.7 1.4 1.1 0.8 0.5 0.2 -0.1 -0.4 -0.7

EUR/USD Interest rate difference, 2y gov. bond (GER minus US) (r.h.s)
Source: Thomson Reuters, Raiffeisen RESEARCH

Short-term outlook
The Greek parliaments approval of a massive austerity package at the end of June paved the way for further support for the debt-ridden country. In early July, the EU finance ministers already released the next tranche of EUR 12 bn from the old aid programme. The Greek government desperately needs these funds to be able to service outstanding bonds which are maturing in July and August. The IMFs approval of releasing this tranche of the loan was given on 8 July. The EU finance ministers also made good progress towards a second aid programme. The overall conditions now appear to be in place and the last remaining question is how to involve private investors. There is now a specific proposal from France which for French banks holding Greek bonds would ultimately amount to a voluntary lengthening of maturities to 30 years. German banks and insurance companies have already indicated their willingness to go along with this model. The euro reacted positively to this development and has since gained tangibly against the US dollar and the Swiss franc. We see potential for more EUR appreciation in the weeks ahead. In this regard, the main driver continues to be the difference between the monetary policies being pursued by the US Fed and the ECB. With the latest dip in economic performance, the US central bank is determined to stick with its zero-interest rate policy longer than previously assumed. As a result, hikes in US interest rates before well into 2012 are no longer an issue. By contrast, the European Central Bank has made it clear that the current economic conditions and elevated price pressure required further normalisation of interest rate levels. Another step in this direction was taken by the ECB policymakers this last Thursday, as they raised the key rate by another 0.25% to 1.5%. Another one or two hikes should follow by year end. As a result, the interest rate differential in favour of the

Economic expectations as a key factor

1.50 1.45 1.40 1.35 1.30 1.25 1.20 Jun-10 Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 0.0 -0.4 -0.8 -1.2 -1.6 -2.0 -2.4

USD/EUR expected growth difference* 2010 (r.h.s.) 2011 (r.h.s.) 2012 (r.h.s.)
* Difference in the anticipated growth in real GDP for the Eurozone and the USA, according to Consensus Forecast Source: Thomson Reuters, Raiffeisen RESEARCH

EUR - USD

euro should widen. This in turn boosts the popularity of so-called carry trades, i.e. taking on debt in USD and investing the funds in EUR. Accordingly, by the autumn we expect to see the euro appreciate to 1.50 versus the greenback. But it is important to note that this will not be a one-way street: temporary setbacks are not only possible, they are likely because the Hydra-like sovereign debt crisis has not been overcome yet. Following the latest blow in the form of more aid for Greece, the rating agencies turned out to be the heads that grew back: first, the rating agency S&P announced that it would view participation of private investors in further aid measures, as envisaged in the French plan, as a selective default at least, i.e. as default on certain Greek bonds. The ECB, on the other hand, wishes to avoid at any cost the resultant triggering of credit default insurance, so-called Credit Default Swaps (CDS), because in such a case the ECB would no longer be able to accept Greek bonds as collateral, which is a much more serious consequence. In that scenario, the Greek banking sector would be essentially guaranteed to collapse. Although we expect that the EU and the IMF will eventually be able to agree on a package of measures which does not trigger default in the view of the rating agencies, statements like this from the rating agencies certainly do not make it any easier to find a solution to the debt crisis. The same holds true for the move by Moodys: on July 5, the rating agency downgraded Portugals rating by four notches from Baa1 to Ba2. As a result, Portuguese government bonds no longer have investment grade status. But the explanation for this massive downgrade sounded somewhat bizarre: Moodys is worried that Portugal may not be able to finance itself on the capital market at reasonable conditions in the foreseeable future. In response to the downgrade, risk premiums on Portuguese government bonds jumped sharply, in particular because many institutional investors are not allowed to hold instruments which do not have an investment grade rating and thus had to sell off these securities en masse. Consequently, the downgrade by Moodys could turn out to be a self-fulfilling prophecy. Clearly, more time is going to pass before the monstrous Eurozone sovereign debt crisis is finally defeated. And until then, the euro will frequently be knocked off of the trajectory which is dictated by the fundamentals.

government bonds should also start rising by then at the latest. This should support the US dollar. Purely fundamental considerations also seem to be more in favour the US dollar over the long term. According to the OECD a fair exchange rate for EUR/USD is currently just below EUR/USD 1.25, on the basis of purchasing power parity. Although this method is not suitable for explaining short-term movements in the exchange rate, over the long term purchasing power parity represents a very good anchor around which an exchange rate moves. According to this approach, there is more potential for the greenback to appreciate from the current levels.

Dollar has mild appreciation potential

2.2 2.0 1.8 1.6 1.4 1.2 1.0 0.8 0.6 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011 EUR/USD exchange rate (calculated back before 1996) OECD Purchasing power parity
Source: Thomson Reuters, Raiffeisen RESEARCH

Medium- and long-term outlook

Over a horizon of 12 months, we continue to see a likelihood that the US dollar will appreciate. Starting from the middle of next year, the interest rate differential in favour of the euro should stop widening. At the moment, we believe that the Fed will begin to tighten its monetary policy in Q2 2012. Yields on US 3

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EUR - USD
This report was completed on 13 July 2011.

Acknowledgements

Editor
Raiffeisen RESEARCH GmbH A-1030 Vienna, Am Stadtpark 9 Telefon: +43 1 717 07-1521 Economics and Financial Markets Research Head: Peter Brezinschek (1517) Research Sales: Werner Weingraber (5975) Economics, Fixed Income, FX: Valentin Hofsttter (Head, 1685), Jrg Angele (1687), Wolfgang Ernst (1500), Gunter Deuber (5707), Ingo Jungwirth (2139), Julia Neudorfer (5842), Andreas Schwabe (1389), Gintaras Shlizhyus (1343), Gottfried Steindl (1523), Martin Stelzeneder (1614) Credit/Corporate Bonds: Christoph Klaper (Head, 1652), Christoph Ibser (5913), Igor Kovacic (6732), Martin Kutny (2013), Peter Onofrej (2049), Gleb Shpilevoy (1461), Alexander Sklemin (1212), Jrgen Walter (5932) Stocks: Helge Rechberger (Head, 1533), Aaron Alber (1513), Christian Hinterwallner (1633), Jrn Lange (5934), Hannes Loacker (1885), Richard Malzer (5935), Johannes Mattner (1463), Christine Nowak (1625), Leopold Salcher (2176), Andreas Schiller (1358), Connie Schmann (2178), Magdalena Wasowicz (2169) Quant Research/Emerging Markets: Veronika Lammer (Head, 3741), Mario Annau (1355), Lydia Kranner (1609), Nina Kukic (1635), Albert Moik (1593), Manuel Schuster (1529) Technical analysis: Stefan Memmer (1421), Robert Schittler (1537)

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