FX Strategies in 2005: U.S. Dollar Versus Euro

Abstract

Riding the early morning Metro North train from Grand Central to Greenwich in late December 2004, the euro dominated Luke Anthony's thoughts. After bottoming out at about 0.85 $/€, in 2000 and 2001, the euro had appreciated sharply and now stood at 1.35 $/€ (Exhibit 1). Luke, an FX Strategist at a hedge fund, had to form a view about the likely path of the euro going forward. The evidence was in no way clear cut. Of the traditional factors, some were pointing toward further euro appreciation, but others seemed to favor the dollar. And there were a host of “new” factors to sift through. Sorting through the evidence would require both relatively standard thinking about foreign exchange markets and the more recent emphasis on prospective capital flows. And Luke had only this quiet week between Christmas and New Year's to form a cohesive plan for early 2005.

Excerpt

UVA-BP-0506

FX Strategies in 2005: U. S. Dollar VERSUS Euro

As Luke Anthony was riding the early morning Metro North train from Grand Central to Greenwich in late December 2004, the euro dominated his thoughts. After bottoming out at about 0.85 USD/EUR in 2000 and 2001, the euro had appreciated sharply and now stood at 1.35 USD/EUR (Exhibit 1). Anthony, a foreign-exchange (FX or forex) strategist at a hedge fund, had to form a view about the likely path of the euro going forward. The evidence was in no way clear cut. Of the traditional factors, some were pointing toward further euro appreciation, but others seemed to favor the dollar. And there were a host of “new” factors to sift through. Sorting through the evidence would require both relatively standard thinking about forex markets and the more recent emphasis on prospective capital flows. Luke had only a quiet week between Christmas and New Year's to form a cohesive plan for early 2005.

Background: The Advent of the Euro and the European Central Bank (ECB)

The euro was launched at a rate of 1.16675 USD/EUR on January 1, 1999, when the currencies of 11 countries—Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain—ceased to exist. At that time the 11 countries delegated monetary policy to the newly formed European Central Bank (ECB) in Frankfurt. The euro immediately became a major international currency, second only to the dollar. Along some economic and financial dimensions, the euro area countries were a close match for the United States. Their combined GDP in 1998 was $ 6.6 trillion, compared with America's $ 8.5 trillion. Their share of international trade outside the euro area (19%) was slightly larger than that of the United States (17%). Taken together, bond markets in euro countries were only somewhat smaller than America's, but their equity markets were much smaller than Wall Street, in part because extensive cross-holdings retarded equity market growth. The euro area had one blemish that was impossible to hide: It suffered from “eurosclerosis,” or persistently high unemployment; at 10%, unemployment was far higher than U.S. levels.

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Keywords: exchange rate determination, capital flows