Although Europe never loses its appeal as a romantic vacation spot, its currency has lost much of its charm. The euro is now trading at its lowest level in almost 12 months against the U.S. dollar, as recent economic data shows a sharp contrast between the two economies.
Last week, the eurozone (EZ) announced that its gross domestic product stagnated at 0.7%, with its three biggest economies failing to expand. Germany fell into negative growth for the first time in a year, France was unchanged, and Italy plunged into its third recession since 2008. Compared to the robust 4% growth in the U.S., the EZ looks downright dismal. Inflation in the EZ is 0.4%, the weakest in almost five years, and its unemployment rate is 11.5%. German factory orders, industrial production, and business confidence are all coming out much weaker than expected. Indeed, the market is wondering whether there is even a framework to create new jobs in the EZ, as it continues to focus on austerity measures, rather than fiscal stimulus. But above all, what’s lacking is a fiscal union. This past week, Nobel laureate Joseph Stiglitz labeled the EZ a “dismal failure,” citing that “monetary policy can’t really be a substitute for fiscal union” and that the pace of construction of a European banking union was just too slow.
While the U.S. is focusing on Fed tapering, many feel that the European Central Bank will pursue quantitative easing. The interest rate differential reflects that expectation, with yield spreads reaching historically high levels. The two-year differential between the U.S. and Germany, for example, is close to about 45 basis points; widening from 15 basis points earlier this year – the widest spread that we have seen in a long time. In the 10 -year sector, the U.S.-German yield differential is the largest since 1999. But the truly alarming thing is how low the 10-year Bund yield has fallen – below 1%, an unprecedented level in history.
All of this has driven the search for yield out of Europe, and funneled money back into the U.S. dollar.
My view: I believe the euro’s new lower range reflects its fundamentals more accurately. While this drop was widely expected, we’re now realizing that the super-low interest rates in the EZ have created a side effect of pulling down our U.S. long-term interest rate even though we are coming out of recession much faster. This only helps our stock market, and restores some of the luster to the U.S. dollar.
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