Short

The Demise of Euro Is Not Greatly Exaggerated

The U.S. dollar reached 1:1 parity with Euro on Tuesday for the first time in 20 years.

Wall Street may tell you that the common currency for 19 European countries has been hammered by economic woes, high inflation, and an energy supply crisis brought by the Russia-Ukraine conflict. I have a very straight-forward answer to the depreciation of the Euro. It is in a simple mathematical formula.

In economics, Interest rate parity (IRP) states that the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. The formula for IRP is:
F0=S0×[(1+ ic)/(1+ib)], where:
F0=Forward Rate, S0=Spot Rate;
ic=Interest rate in country c; ib=Interest rate in country b

Inputs: The Fed raised rates three times from 0.0%-0.25% to current target of 1.50%-1.75% (ib). Meanwhile, the European Central Bank (ECB) maintains a deposit rate of -0.5% (ic). Before the first Fed rate hike in March, the Euro/USD spot rate was 1.04 (S0).

Output: Plug the data into the IRP formula, you will get a forward rate of 1.017 (F0). This matches the observed exchange rate after the June rate hike.

New Output: The market expects the Fed to raise another 75 bps on July 26th-27th. If we replace 1.75% with 2.50% in ib, the new Euro/USD forward rate would be 1.0096 (F1).

Let’s explain this in plain English:
An investor has the option of investing in either U.S. dollar or Euro. With higher rate, dollar asset produces a higher return. To make Euro more attractive, the investor would need more euros per unit of U.S. dollar. Therefore, Euro depreciates against the dollar. This is the logic behind IRP. It is called the Law of One Price.

If we believe that the Fed would keep raising interest rates, and it would do so at a faster pace than the ECB, then Euro would continue to fall. By how much? You could try to work out your own estimate by plugging in different Fed and ECB interest rates at the IRP formula.

I recognize that many factors would impact exchange rates. A framework using IRP is a simplified but effective way to construct a FX trading strategy. All the other factors can be viewed as variables influencing the rate decisions.

Asides from the mathematical approach, we could consider a country’s currency to be reflective of its economic strength. Looking back at the last two decades since Euro’s inception, the European Union, and the Euro Zone in particular, has been outpaced by the United States in terms of GDP. Taking the GDP in 2000 as a baseline index 100, the U.S. has now reached 155, while the EU (excluding Britain) is at 133, and the Euro zone at 128, according to an analysis by the Economist.

Whether it was the Subprime crisis in 2008, or the debt crisis in 2010, it took the EU economy much longer to recover comparing to the United States.

Brexit raised a red flag of the long-term viability of a political and economic union of independent countries. If history is a guide, I can’t find a good case where one common currency existed among multiple nations for an extended period of time. Exceptions could only be found between an empire and its colonies. Europe would strive, but would a common currency need to be there?

A short position in CME Euro-FX futures (6E) is a way to express this bearish view. The March (6EH3) contract may be a good choice. It was settled at 1.02415 on July 12th. There are five Fed meetings between now and contract expiration. Each rate-setting decision could potentially shock the Euro into further decline, in my opinion. Each contract has a notional value of €125,000. CME requires an initial margin of $2,400. For a short position, a decline (increase) of 1 basis point (0.01%) in the exchange rate of Euro will result in $12.50 in gain (loss) in your account balance.

Happy Trading.

Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.

JimHuangChicago

Jim W. Huang, CFA
jimwenhuang@gmail.com

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