2002: Euro Deja Vu?

2002: Euro Deja Vu?

The stalling EUR/USD rally of the 3rd week of December 2001 is starting to look a lot like deja vu. The notable drop to the 89.50-cent support on Dec 19, reveals again to euro bulls that the currency has no strength of its own. In fact, in its history of brief rallies the euro has shown that it is not a leader, but a follower of weak leaders. Therefore, judging by past performances the latest rally could draw to a close by year-end.

Past Rallies Prove Strong But Unsustainable

1) May 19-June 16 2000 (9.5% in 4 weeks)

Defended the 88.45-cent mark and rallied to 97-cents before reversing and falling to its October 26, 2000 all-time low of 82.25.

- The main catalyst was speculation that the ECB could intervene to support the euro as it was hovering around an all-time low of 88.45. ECB ends up intervening for the first time on September 22 around 85.50.

2) Nov 24-Jan 5 2001 (17% in 6 weeks)

Soars to 95.94 cents from an all-time low of 82.25, before beginning a 6-month sell-off to 83.50 on July 5.

- ECB had to perform 3 solo interventions in the first week of November to show it was serious about defending the currency’s life-long slide.
- US economy shows increasing signs of weakness, dragging USD lower.

3) July 6-Sept 19 2001 (12% in 6 weeks)

Rises from 83.50 to 93.26, then falls to 87.35 on November 23.

- V-shaped recovery proves elusive as new signs of weakness in the US economy emerge.
- Protests by US trade manufacturers that the dollar is overvalued leads to a diplomatic shying away from the 8-year old strong dollar policy.

4) Nov 24- Dec 17 (4% in 4 weeks)

Rises from 87.35 to 90.78 on December 17.

- Japanese monetary officials talk down the yen and call the euro “undervalued”.
- Surprise drop in US consumer confidence sparks renewed fears of a prolonged US economic downturn.

Rally in EUR/USD Supported by GBP Gains and JPY Losses

An interesting aspect of the latest EUR/USD rally is the extent to which the fall in JPY has been leveraged to the euro’s advantage over the dollar.

JPY reached new multi-year lows in December, passing previous lows reached in April. Using these levels as a point of comparison one can see that sterling strength and yen weakness were key drivers in the EUR/USD rally, rather than strength in the euro itself.

GBP and JPY Strength are Key Drivers of EUR/USD



- The pound was the biggest gainer, rising 3.3% above its April high against the yen, and leveraged this strength to rise one cent above its April high vs. the dollar.
- EUR/JPY rose 2% above its April high but EUR/USD was actually lower than last April’s high.
- Therefore, given the sharp rises in EUR/JPY (8.5% in 4 weeks) and GBP/USD (7.5% in 4 weeks) compared to USD/JPY (6.5% in 4 weeks) any correction in JPY will likely to pull EUR/USD and GBP/USD down with it.

Trend Is Not Euro’s Friend

Looking back on past rallies in EUR/USD there are 3 striking similarities.

- Rallies occur more over negative sentiment in other currencies than positive euro factors.
- Duration of rallies average a mere 5.5 weeks, which makes euro bulls increasingly pessimistic about betting on a sustained rally.
- Seasonal bond and equity flows support the euro in Q2 and Q4 three years running.

These trends suggest that the current rise in EUR/USD looks in peril of fading by year-end unless it can find its own reason to sustain a move higher in 2002.

This will be difficult given the likely pickup in investment flows towards the US in 2002.

Money Flows Likely to Favor USD in 2002

Unless there is a continued slowdown in financial flows leaving the Eurozone to the US, EUR/USD is likely to come under renewed pressure in January.

Last year’s December rise and January decline in EUR/USD can be attributed to the fact that European investment managers hold off on new buying of US stocks and bonds until after the holiday. This “holiday effect” can be observed by the May/July and Nov/Dec rallies as reduced capital market activity temporarily diminishes portfolio related flows into the US, thus weighing on the dollar.

More daunting for the euro still is that this year’s money flow into the US could prove even stronger than last January because of the large amount of money still sitting on the sidelines. This makes the outlook for EUR/USD bearish in January and February 2002.

Moreover, these capital flows include both portfolio investments (US stocks, bonds and money market instruments) and foreign direct investment. According to the US Treasury, foreign direct investment from the Eurozone to US slowed considerably in 2001, to $18.7 billion in Q1-Q3 2001, or an annualized rate of $28 billion. This is down from the near record $124 billion in 2000. Recall that the Eurozone was the largest provider of M&A flows to the US in 2000. The main underlying reason to such decline is the current global economic slowdown, rather just a US-related phenomenon.

The Vivendi/USA merger only highlighted the fact that M&A flows will continue to be dollar supportive into 2002.

In fact, the new Eurozone labor law passed on Tuesday (making firing workers even more difficult) should add to the outward investment flow as M&A activity picks up in 2002.

Ultimately, these asset flows have been the principal factor behind a strong dollar and why the dollar continues to rally against the European currencies despite low interest rates and slow growth.