What’s up with the Euro?
Don’t read too much into euro exchange rate moves, including the recent strength against sterling. The euro started life at a point in which the DM was generally weak and well below purchasing power parities so everything since needs to be seen in that context. Splicing the euro onto the DM and plotting relative inflation rates since 1969, we think the meaningful ‘parity’ for the euro against sterling is not 1 but the fact that a rate of around 1 is now quite close to purchasing power parity for the first time in the short history of the euro.
Short-term movements may have been driven more by the scale and speed of governments’ most recent policy responses to the banking crisis. The UK’s may have made sterling look an easy target, and the euro the best other side of the trade at a time when the dollar and yen were seen as being technically overbought. Aside from trading, a young monetary union with members whose exposure to debt problems is hugely disparate must carry a small failure risk with very big consequences, compared with the directional risks associated with a single currency, even if it is one with relatively high sensitivity to those problems like sterling. The problem investors should worry about is not sterling so much as inflation, which may be a global consequence of policy decisions being taken today. More on that anon.