Why is the Euro Gaining so Much Ground Against the Dollar?

Last week: The U.S. economy is struggling to navigate against strong headwinds. Real consumer spending rose by 0.3 percent in February, while real income actually fell 0.1 percent. Consumers cannot continue to spend when both income and consumer expectations are falling. Consumers are paying more for gasoline and groceries at a time when income gains are slow. If that is the state of two-thirds of the total economy, it is clear that even with some job growth, the economy is going to remain more modest than moderate this spring.

THE SITUATION ABROAD

The global economy had been on pace to expand by about 4 percent this year, with the emerging countries growing at least twice as fast as advanced countries. The unrest in the Middle East would not have been, in itself, enough to nudge the entire global economy off this trend. The disasters in Japan are another matter. The loss of up 25 percent of utility output is resulting in the shutdown of part production for some auto and electric assemblers. Given today’s elongated and integrated supply chain, some assembly in the Asia/Pacific and North American regions is being affected. There remains no definitive answer to how long it will take to replace utility losses. Some estimates suggest that global growth in the second quarter of this year may be constrained by as much as a full percent. The impact likely won’t be quite that severe. For the second half of 2011, the recovery in activity could be as large as the downturn this spring.

FACT OF THE WEEK

30.4 percent. When the U.S. housing market began to contract in 2007, few if any expected the declines would stretch into 2011 or be this severe. The value of the average home is almost a third lower—30.4 percent to be exact—today than it was at the start of 2007. Two years after the recession officially ended, the contraction in housing is far from over. A third of all those with mortgages owe more than they would make by selling the property. And that, in turn, suggests prices are headed lower still for a time, before finally turning around. Could they drop another 5 percent? More importantly, will 2012 finally witness an upturn in the housing market? Possibly—especially if growth in the number of homeowners falling behind on their mortgages is at least slowing down.

QUESTION OF THE WEEK

With all the public debt problems Europe faces—and economic growth weaker in the euro-zone than the U.S.—why is the euro gaining so much ground against the dollar?

The easy answer is that inflation is higher in the U.S., and interest rates are lower; thus investors can earn more money investing in euro-denominated securities, and have less of those earnings eroded by inflation. Through February, retail inflation in the euro-zone averages not quite 0.5 percent, while the U.S. CPI is rising at about 1.5 percent. Yet, a 10-year U.S. Treasury bond has a current yield of more than 3.5 percent while a 10-year euro bond yields almost 4.5 percent. Consequently, money is flowing into euro securities, sending the euro higher: One euro is worth $1.4 dollars this week.

Is this situation likely to persist? No. For one thing, Germany imports more from China than almost any other economy in the euro-zone. This is important because the Chinese currency is appreciating and Chinese export prices are up about 5 percent from a year ago. Thus Germany is effectively importing higher costs, which is very likely to drive its production costs up, and in the process leveling the playing field in the euro-zone a little. As this process plays out, the return on euro securities relative to dollar-denominated securities is likely to narrow, no matter what happens to the debt crisis. In short, the euro once more is enjoying a premium, for now.