The euro: Good bet or fool's paradise?

Euro coin and UK banknote Image copyright Getty Images
Image caption Some experts predict the euro could soon hit parity with sterling

Today the pound hit a seven-year high against the euro. Or perhaps another, more accurate, way of thinking about that is that the euro hit a seven-year low against the pound. Against the US dollar, the euro is trading an eleven-year low.

Increasingly, analysts are predicting that this trend will continue and the euro-dollar exchange rate will hit "parity" ($1 = €1) in the coming months for the first time since 2002.

With the eurozone still being Britain's single largest trading partner, the exchange rate matters. A weaker euro makes UK exports to the single currency area more pricey and lowers the costs of imports from across the Channel.

To understand if this trend towards a weaker euro will continue, we need to work out what is driving it. But first it's important to remember that in many ways forecasting exchange rates with any accuracy is a bit of mug's game. So with that caveat out of the way, this is what looks to be happening.

Some of the weakness in the euro reflects renewed fears about a Greek exit from the single currency. That may be more manageable than in 2012 but the outcome would still lead to disruption and fundamental questions about the euro's future.

But there's a more fundamental factor at work - monetary policy is diverging.

At the moment, the next move from the Bank of England and the US Federal Reserve is expected to be raising interest rates. Meanwhile the European Central Bank (ECB) has just begun a programme of quantitative easing (QE) - electronically creating money to buy-up government debt in the eurozone.

It's this divergence, between monetary tightening in the US and the UK, and easing in the eurozone, which is driving the euro lower.

To understand why, we need to look at the yields (the interest rate paid) on government debt. Today a two-year US government bond yields 0.7% and two-year UK government bond yields 0.6%. By contrast, a two-year German government bond has a yield of -0.2%.

In other words, an investor who buys a two-year German government bond today and holds it to maturity, will lose 0.2% a year. The price of the bond - which moves inversely to the yield (as prices rise the interest rate comes down and vice versa) - is so high, that loss is almost guaranteed.

Given these sort of rates, it's no surprise that those who can choose where to hold their money, are finding the pound and the dollar more attractive than the euro.

Over a third of all government debt in the eurozone is now trading with a negative yield. That, it must be said, is an unusual state of affairs.

There are couple of possible reasons why investors might choose to buy government debt with a negative return. It could be that they fear losing money elsewhere and so would rather park their cash in a safe haven that will suffer a small loss, rather than risk losing more elsewhere.

But inflows of money into riskier European assets like stocks are on the rise, which does not suggest a high level of fear.

Image copyright Getty Images
Image caption The new European Central Bank headquarters in Frankfurt

So we are left with the other explanation, which is, investors hope to sell on their pricey government debt to someone else for a higher price than they paid. This is what can be thought of as the "greater fool theory" of investing. It might be foolish to buy something that looks overvalued but, as long as a bigger "fool" can be found to buy it for more later, then a profit can be made.

At the moment, the European Central Bank - by pledging to buy €60bn (£43bn) of government bonds a month until September next year - is the "fool" of choice. Why not buy a German 10-year bond at a yield of 0.1% if you think you'll be able to sell it to the ECB for more later? And as long as that is the case, the euro should continue to weaken.

Of course, the ECB is not necessarily being "foolish". The purpose of QE, from its point of view, is not to make money in the bond markets but to boost the European economy.

There are two factors, though, that could change this state of affairs.

It may be that a stronger pound and stronger dollar - which could crimp exports and lower inflation through reducing import costs - force the Federal Reserve and the Bank of England to think again on rate rises.

This would make the divergence in monetary policy less extreme and make the euro more attractive to hold.

Or - and this is not yet the central forecast of many - it may be the ECB thinks again on QE.

Just six weeks ago when the programme was introduced, one of the most common responses was to ask: "Is €60bn a month until September 2016 really enough?" The assumption of many was that the eurozone economy was in such a deep hole that more QE would be required.

But the eurozone economy is now showing signs of recovery. Even in the past few weeks, the outlook has brightened. It may not be long before the question starts to change. Rather than it being "has the ECB committed to too little QE?", it could become "has the ECB committed to too much QE?".

In other words, if the eurozone economy shows further signs of firming, the markets may start to question quite how committed the European Central Bank really is to QE.

At that point, the present bout of euro weakness - and some of those rather odd negative interest rates - could reverse. Those who had bought eurozone government bonds hoping to sell them on to a greater fool, would look rather foolish.

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