In today’s article, we think it could be good to recap the History of the Euro and the previous engagements European countries had before switching to a single currency regime. This post is split in two parts, the first one focuses on the most important events and treaties that led to the adoption of the single currency. In the second part, we explain the trends and reversals of the single currency vis-à-vis the US Dollar in addition to stating what we believe were the main drivers of the currency pair.
The Euro is part of the G3 currencies (with the Yen and the US Dollar) and is the second most ‘traded’ currency with a daily average of 1,591 Billion Dollars according to BIS report on FX volumes in April 2016. If the Foreign Exchange market’s daily volume equals roughly 5 trillion USD, then the Euro’s percentage share of average daily turnover stands at 31% approximately, far below the USD Dollar and its 89%. Note that two currencies are involved in each transaction, therefore the sum of all the percentage share of individual currencies totals 200 percent.
I. The political face of the Euro
Even though the Euro came into existence on January 1st 1999, currencies of countries in the European Union (under the Exchange Rate Mechanism that we will see later on) were not allowed to float freely against each other between the early 1970s (end of Bretton Woods) and the Euro inception day (1999). Hence, it is hard to believe that European Leaders will let the currency down by accepting a country to leave the Euro Zone (i.e. Greece or Italy) because for the main reason that it has been a Political project for more than 60 years.
Although it would take me more than a life-time to precisely study step by step the creation of European Union after WWII, this part will only focus on a few important political events that will be useful for a FX history research.
A. Introduction: Post WWII ‘cluster’
So the first international organisation to unify six Continental European countries after WWII was called the European Coal and Steel Community (ECSC) and was established in 1951 by the Treaty of Paris (signed by France, Belgium, West Germany, Italy, the Netherlands and Luxembourg). In 1958, the Treaty of Rome came into place (signed by the same six countries in March 1957) and created the European Economic Community (ECC). It still remains one of the most important Treaties of the EU history; in short, it proposed the progressive reduction of customs duties, the establishment of customs union and the creation of a single market for goods, labour, services and capital. Alongside the ECC, the European Atomic Energy Community was established by the Euratom Treaty, with the purpose of creating a specialist market for nuclear power in Europe in addition to energy development and distribution.
As you can see it on the ‘history map’ (Picture 1), between 1958 and the early 1970s, the European Union was ‘represented’ by three Communities (ECC, ECSC and Euratom), which eventually merged in 1967 (Brussels Treaty) to form a single institutional structure.
Until the early 1970s (end of Bretton Woods: 1971 – 1973), all the six countries were part of the Bretton Woods system, therefore there wasn’t any ‘action’ in the FX market then. You can see below at which rate the currencies were pegged to the US Dollar (table 1).
Table 1. Exchange Rates versus the US Dollar during the three Communities (Source: Bloomberg)
||Currency vs. 1 unit of USD
|West Germany (DEM)
|French Franc (FRF)
|Italian Lira (ITL)
|Luxembourg Franc (LUF)
|Belgium Franc (BEF)
|Dutch Guilder (NLG)
B. The 1970s: after the Nixon Shock.
The Nixon announcement – convertibility suspension of USD into gold – on August 15th 1971 was followed by the Smithsonian Agreements signed by the Group of Ten (or G-10) in December 1971. In short, the countries accepted a US Dollar devaluation of roughly 8% against Gold (from $35 to $38 an ounce), wider trading bands of 2.25% (vs. 1% before) and some [countries] agreed to sharply appreciate their currency against the US Dollar (JPY + 16.9%, DEM and GBP +13.6%, FRF +8.6% and ITL +7.5%). This agreement’s objective was to devalue the US Dollar in the time when the US was running negative balance of payments and important deficits as a consequence of the Vietnam War and the Great Society program (launched by President Johnson in the mid-60s, the aim was the elimination of poverty and radical justice).
However, under these new [but smoother] restrictions, the snake in the tunnel was adopted in attempt to limit fluctuations between EEC currencies. As a reminder, during the Smithsonian Agreement, EEC currencies were allowed to trade within a 2.25% band against the US Dollar. This means that if the Italian Lira started suddenly to depreciate from the low of its band to the high of its band, this would result in a total 4.5% depreciation against the US Dollar. On the other hand, if the Deutsche Mark started to appreciate from the high to the low of its band, this would result in a total 4.5% appreciation. Therefore, if both happened simultaneously, the Deutsche Mark would appreciated by 9% against the Italian Lira. The Basel agreement (April 10th 1972) judged that the movement was too excessive and set a maximum change of 4.5% between two EEC currencies as well.
Even though it bought the US some time to regain some competiveness in the market after the Agreement, the US Dollar continued to fall dramatically in the 1970s (as a response to inflation rising from the two oil shocks) and countries were forced to quit the currency snake. For instance, the British Pound, which joined the snake in May 1972, left it a couple of months later. Italy left the snake in January 1973, followed by France in 1974 and again in 1976 after joining back. By 1977. The currency snake became a ‘Deutsche Mark zone’ with four trackers: Belgium and Luxembourg Francs, the Dutch guilder and the Danish Krone (that joined the EEC on January 1st with Ireland and United Kingdom).
As we can see, depriving currencies to fluctuate freely between each other under the Currency Snake was a failure in the 1970s, but it didn’t stop the ECC officials to continue to work on a European Monetary System.
C. 1979: The European Monetary System
In March 1979, with the adoption of the European Monetary System (EMS) under the Jenkins European Commission, all nations of the EEC (Except United Kingdom) agreed to link their currencies under the Exchange Rate Mechanism in order to prevent large fluctuations and achieve monetary stability across in Europe. Picture 2 shows the historical exchange rate regimes for European Countries since 1979:
- The colour Grey represents members of the ERM (currency pegs to ECU)
- The colour Blue represents the members of the Euro Zone ( 19 countries)
- The colour Yellow represents countries members of the European Union, but outside of the ERM. For instance, Croatia joined the EU in 2013 but still has a ‘floating’ exchange rate (though it looks like the Croatian Monetary Authority has been trying to set the exchange rate at 7.6 HRK against the Euro with a trading band of roughly 2%)
- The colour Green represents members of the EU, outside the ERM but with a currency pegged to the Euro (i.e. Bulgarian Lev BGN is set at 1.96 per unit of EUR)
Under the EMS arrangement, the European Currency Unit (ECU) – a basket of the currencies of the European Community members – was defined and used as the unit of account before becoming the Euro in 1999. Even though no currencies was designated as an anchor, the Deutsche Market (along with the Bundesbank) became the centre of the EMS very quickly (DEM had other 30% of currency weigh to the ECU between 1979 and 1999, followed by France with 20%). Therefore, in the 1980s, the DEM, the GBP and the USD became three main currencies traded by market participants (an interesting documentary about currency trading called ‘Billion Dollar Day’ was produced by the BBC in 1985 and looks at one day – 24 hours – of FX trading).
As you can see it in picture 2, two countries had to withdrew from the ERM due to economic policies divergence and speculative: Italy withdrew from ERM on September 17th 1992 after a 7-percent devaluation 4 days earlier (re-entered in Q4 1996) and the UK withdrew from ERM on September 17th 1992 after Black Wednesday a day earlier (and never re-entered).
In addition, broad margins were also increase to 15% in August 1993 to allow currencies to accommodate speculation against other currencies (French Franc in 1992-1993).
D. The Maastricht Treaty
Before switching to Euro’s birth and the single currency potential drivers, another important Treaty signed on February 7th 1992 was the Maastricht Treaty, which created the European Union and led the creation of the Euro. It set the convergence criteria for a country to qualify for participation in EMU, which are the following ones:
- Inflation within 1.5 percent of the best three countries of the EU for at least one year
- Nominal long-term interest rates are required to be within 2% points of the best three in the EU for at least a year
- Applicants countries have to be in the ‘narrow’ band of the ERM-II without tensions (and depreciation) for at least two years
- Fiscal discipline: a budget deficit to GDP ratio of nor more than 3 percent and government debt-to-GDP ratio of no more than 60%
The treaty entered into force on November 1st 1993 and has been amended by the treaties of Amsterdam, Nice and Lisbon since then.
II. Study of trends, reversals and main drivers of the single currency since Inception
A. January 1st 1999: the launch of the Euro and the constant three-year depreciation
After four decades of effort, the single currency was born virtually in 1999 and in 2002 coins and notes began to circulate. At that time, there were 11 members and the US Dollar was trading at an initial value of 1.1685 against the Euro (the pound was buying roughly 1.42 euros at that time). However, the single currency suffered three years of depreciation against the US Dollar after its launch and hit an historical all-time low of $0.8230 in October 2000 according to Bloomberg data (chart 1).
There have been many explanations for the Euro 1999-2002 depreciation; some economists used the productivity differential to explain the USD/EUR exchange rate (Corsetti and Pesenti, 1999, Chinn and Alquist, 2002 Schnatz et al., 2004), others used a set of macroeconomic variable – growth rate, inflation differentials, current accounts – (De Grauwe, 2000, De Grauwe and Grimaldi, 2005), or a surge in the equity market capitalization in the US since the mid-1990s leading to a large positive demand shock and a US Dollar appreciation (Meredith, 2001). Even though these explanations could be convincing broadly financially speaking, most of them fail to explain the Euro weakness (vs. the US Dollar) empirically. Therefore, the depreciation of the Euro from 1999 to 2002 remains a puzzle and a fair conclusion to that depreciation period could be that the single currency wasn’t perceived as a full-pledge money by consumers and investors until the introduction of Euro coins and notes in 2002 (Shams, 2005).
B. The 2002 – 2008 appreciation
After notes and coins came into circulation (and National banknotes and coins were finally withdrawn from use), the Euro started its appreciation period against the greenback and almost double in value in 7 years; it soared from a historical low of 82.30 cents vs. USD to a historical high of $1.6040 reached in July 2008.
As the Euro Area GDP quickly reached 10tr USD in 2004 (vs. 12.5tr USD for the US at that time), it became the second world’s largest economy and therefore the importance of the Euro as an international currency was starting to increase. There are several explanations to the Euro appreciation against the USD:
- Divergence in the Current Accounts
Between 2000 and 2007, the US Current Account deficit widened from 4% to 7% of the country’s GDP (appendix 1), while the EZ Current Account was improving and slightly positive (+1% of GDP in 2004).
The large CA deficits could have been partially explained by the fact the US has a low savings rate (Summers, 2014); the deterioration of the national saving rate (percentage of GDP that entities in an economy such as households, businesses and governments themselves save over a fixed period of time) between 1990s and 2000s has led to increase in the current account deficits in the US (a current account deficit is the difference between national savings and national investments, the deterioration of the national savings).
- A Weak US Dollar
This period was also associated with a long weak US Dollar period. The greenback was not only depreciating against the Euro, but most of the currencies (Cable rose from $1.40 to over 2.10$ during the same period; USDJPY went down from 120JPY to 70JPY…). This period was also very significant for commodities; gold soared $300 to $1,000 an ounce while oil went up from $18 to over $140 a barrel.
- Interest rate differentials
Another explanation relies the interest rate differentials between Europe and the US; as European interest rates were relatively high compared to US interest rates, it attracted capital inflows in Europe and therefore contributed to the Euro strength.
- Strong European growth
During the 2002-2008 period, the Euro Zone was experiencing strong growth – especially between 2006 and 2008 – and was the engine of global demand growth. Housing and Consumption bubbles in many peripheral countries (Spain, Portugal, Ireland…) generated the so-called positive feedback loop and fuelled its growth.
In many ways, it looked like [during that period] the Euro Zone was stepping into the role of the US had previously played in the global economic system. Some even argued if the single currency will eventually surpass the Dollar as the Leading international currency (Chinn and Frankel, 2005). In their paper, the authors stated that if the US Dollar depreciation persisted in the future and if an important member joined the EMU (i.e. the UK), the Euro may have surpassed the Dollar as a leading international reserve currency by 2022.
C. The 2008 GFC and the Dollar rise.
In the summer of 2008, investors started to look for safety as the threat of a global failure in the system was starting to emerge sharply. Due to the search for safe-havens, both the global flight to safety into US Treasuries and the reversal of the carry trades were sources of Dollar strength. The Euro lost 23% (and 34% resp.) against the US Dollar (v. the Japanese Yen resp.) between the summer 2008 and Q1 of 2009 (chart 1).
In addition, the dollar asset writedowns left European banks and institutional investors outside the US with overhedged dollar books; therefore, squaring their positions required those institutions to purchase US Dollars, and therefore boosted the greenback’s appreciation (McCauley & al., 2009). In those panic moments, investors tend to look for safe-havens and the first questions that come to their minds are: What’s cheap and what’s liquid? The fact that investors bought US Dollar (and Treasuries) in the turn of the year 2000 (after the dotcom bubble popped) played also an important behavioural empirical bias.
To conclude, there was also a dollar shortage after Lehman’s failure in September 2008 that reflected unbalance growth in international banking. As the BIS explained, European banks accumulated dollar assets well beyond their dollar deposits and funded the difference in the interbank market. The banking system suffered from a dollar shortage and the incredible spike in the 1-month and 3-month Yield premium in US Dollar swaps (Figure 1) contributed to a sharp appreciation of the US Dollar.
C. Post GFC: Sovereign Debt Crisis, ‘twin’ deficits, bailouts….
After the 2008 financial crisis [and before May 2014], three major drivers could explain the EURUSD dollar fluctuations:
- The spreads between peripheral and core Euro Zone countries (the first popular one to arise was the German-Greece 10-year spread in 2009/2010, then the second one was the German-Spanish 3-year spread during 2011/2012).
- The ECB-Fed total-asset ratio: looking at the central banks’ balance sheets have become popular after 2008 (see article it is all about CBs), and therefore the ratio between the ECB and the Fed’s balance sheet total assets was an important indicator to look at during that period. The higher the ratio (ECB balance sheet is increasing relatively to the US one), the weaker EURUSD.
- The last indicator was current account differences (between US and EZ). As a consequence of the financial crisis, peripheral European countries were left with massive current account deficits – i.e. 15% in Greece or 13% in Portugal – which obviously accelerated the outflows from Europe and depreciated the currency.
On the top of that, after the establishment of a rescue fund (EFSF and EFSM first, then the ESM in 2012) to assist countries that couldn’t borrow from the market, it took some time for market participants to ‘digest’ it as there was speculation that the maximum lending capacity of €500bn was clearly not enough if EZ countries were falling one by one. More and more countries were considered as recipients [of an ESM bailout] and less and less countries were considered strong guarantors; the Euro Zone was constantly making the headlines between 2009 and 2012 which was each time impacting the Euro.
- 2011 first shot: introduction of new LTROs
In response to the European sovereign debt crisis, the ECB announced a new ‘version’ the long term refinancing operation (LTRO) – a cheap loan scheme for European banks – towards the end of 2011. By definition, the LTROs provide an injection of low interest rate funding to euro zone banks (using sovereign debt as collateral on the loans) and are used to provide longer-term liquidity than standard MROs (main refinancing operations) to banks during times of crisis. Before the financial crisis, the ECB’s longest tender offered was just three months and represented about 20% of the ECB’s liquidity provided. After the crisis hit, the maturity of these LTROs was extended to six months (March 2008) and 12 months (June 2009).
Then, the two rounds that were carried out in December 2011 and February 2012 were expanded to a three-year maturity with a 1% interest rate and the option of repayment after one year. In total, the ECB LTROs provided more than 1 trillion euros of liquidity to euro zone banks to stave off the credit crunch and on hopes that the situation improves (i.e. decrease in peripheral yields).
But the situation deteriorated;, the Euro went down from a lower high of 1.50 (against the US Dollar) in mid-2011 to retest the $1.20 in the summer of 2012 (chart 1). At that time, the ECB balance’s sheet was expanding (thanks to the LTROs) and reached a high of €3.1 trillion in June 2012 (chart 2) while the Fed’s balance sheet was steady after QE2 ended in June 2011 (Operation Twist lasted from September 2011 to December 2012 but didn’t increase the size of the central bank’s balance sheet). In addition, peripheral yields of European countries rocketed during that period; the Italian and Spanish 10-year bond yields were trading at 6.5% and 7.5%, respectively, in the summer of 2012. Investors started to worry that the ESM rescue fund wasn’t strong enough to support countries like Spain or Italy and were starting to fear potential defaults coming ahead. This was clearly not sustainable; Italy was (and is) not able to roll its obligations at a 6%+ yield without and the markets needed a reaction at that time.
2. July 2012: ‘Whatever it takes’ and the introduction of the OMT program
Therefore, that leads us to the famous Draghi’s ‘whatever it takes’ at an investment conference in London on July 26th 2012 (and the extra comment ‘we think the euro is irreversible’) with the introduction of the OMT (Outright Monetary Transactions) program on August 2nd. Even though the OMT was [and still is] considered as a myth by many practitioners and economists, it was ‘enough’ to reverse the trend on peripheral European bond yields, and therefore the Euro. Until May 2014, the Euro became one of the traders’ favourite currencies (with the British pound); click here if you want to read an article that we wrote in February 2014 (The Euro Strength and the ECB’s options) that explains more in details the appreciation of the Euro.
However, in a world where every economy wants a cheap currency, the Euro strength was starting to pause a problem for EZ politicians and policymakers, as inflation expectations were falling towards zero. The 5Y5Y inflation swap rate fell below the 2-percent level (the ECB’s target) in 2014 as you can see in chart 3, increasing doubts on the ECB only mandate. In addition, the Euro strength was causing competitiveness problems for peripheral countries.
D. May 2014: ‘Ready to Act’ and the end of a Euro love story
On May 8th 2014, Draghi announced during his conference that the ECB was comfortable with taking new fresh action (i.e. QE + Negative interest rate policy) at the next meeting in June in order to tackle the lowly inflation rate (and send the Euro down). After that meeting, the ECB decided to go all-in in the next few months and entered into the Currency War Game. At that time, US monetary policy and European monetary policy flipped at the same time (chart 2): while the Fed was tapering its QE3 by 10-billion dollars every month, the ECB announced the market that it will take further measures. The reaction on the Euro was imminent, and the single currency went down from a lower high of 1.40 during that meeting (May 8th) to close at a low of $1.21 at the end of the year 2014.
At the June ECB meeting, Mario Draghi announced a series of measures [as promised] that included cutting the deposit rate into negative territory (-0.10%), targeted LTROs, an extension of the fixed rate full allotment and preparation of European QE. The ECB ‘bazooka’ was finally announced on January 22nd 2015, planning monthly purchases of €60bn of private and public sector debt between March 2015 and September 2016 (bringing the QE size to 1.1tr Euros). The expanded asset purchase program (APP) – i.e. QE – is split in four different categories, which are (ECB website):
- Third covered bond purchase programme (CBPP3)
- Asset-backed securities purchase program (ABSPP)
- Public sector purchase programme (PSPP)
- Corporate sector purchase programme (CSPP)
The Euro continued its negative trend against the US Dollar to hit a low of $1.0450 in March 2015; since then, the pair has been oscillating mainly within the 1.05 – 1.15 range (chart 1), with the exception during the August 24 flash crash in 2015 where the Euro soared with the VIX and rose above 1.17 against the US Dollar. One explanation of the positive 20-day correlation between EURUSD and VIX index (see article here) could be that investors holding European assets such as stocks or bonds (in response to more stimulus) were all hedged (i.e. short EURUSD). Therefore, when the market crashed in August 2015 (Eurostoxx 50 plummeted 20%, chart 4), investors had to buy back Euros in order to not be overhedge, therefore pushing the Euro to higher levels.
III. Current state of the Euro
A. Where do we stand now?
Despite further rate cuts in the deposit rate (-0.4%), an increase in the size and the duration of the QE programme to €80bn and now due to run until March 2017, the Euro has remained flat. Since the beginning of 2015, the Euro has been fluctuating around 1.10 against the dollar, a level which seems to correspond to the ‘fair value’ of the single currency.
The ECB balance sheet has grown to a historical high of 3.5tr EUR, and there are talks that EZ policymakers could run out of paper to buy within the next 12 to 18 months. Figure 2 represents the ECB weekly purchases under the APP program; the central bank usually releases its latest bond purchase data every week by submitting its lists of ISINs. As of October 14th 2016, the total CSPP holdings stood at €33.8bn.
As you can see it on chart 3, despite a 1.5 trillion EUR increase in the ECB balance sheet’s assets, the 5Y5Y inflation has constantly trend lower and now stands at 1.46%. In addition, based on the September macroeconomic projections, the central bank cut its growth outlook for 2017 and 2018 to 1.6% (vs. 1.7%) and its inflation 2017 forecast to 1.2% (vs. 1.3%) as a consequence of Brexit vote.
B. How to weaken the Euro?
As we said earlier, the single currency hasn’t been responding to fundamentals nor core-peripheral spreads since the implementation of QE. we are not part of the school that thinks the Euro needs to be weaken even more, however here are a few factors that could bring the single currency to lower levels in the near future. The first one is political uncertainty rising in Europe; for instance the first event to come is the Italian Constitutional referendum that is planned to be held on December 4th. As you can see on chart 5, the 10-year Italy-German yield spread has surged from 110bps to 160bps (back to post Brexit levels) over the past three months. If the divergence continues to increase ahead of the referendum, the market could react to a potential contagion in Europe and therefore the IT-GE 10-year spread could serve as a proxy of the current political uncertainty in Europe.
The second one comes from a Dollar rise based on a confidence that the Fed is considering starting [again] its monetary policy tightening cycle. The last rate increase was in December last year (25bps), however the market didn’t react very well (SP500 index was down by 13% in January) and the global macro situation in early 2016 (low oil prices, decreasing earnings…) kind of forced the Fed to pause. If we look at the FedWatch Tool (appendix 2), the implied probability of a potential hike stands at 71.5% for the December meeting. Even if we see a rate hike in December, we don’t think the USD reaction will be too significant; EURUSD may trade a 150 / 200 pips lower than its current value, which corresponds to the lower band of this year trading range.
A third reason to think of a Euro depreciation would be that the ECB suddenly announces that it will purchase stocks (like in Japan, there were talks of a potential 400/450bn EUR ETF program). The European Stock market (i.e. Eurostoxx 50) has been a dead market for the past year, oscillating around 3,000 in good times with sharp drawdowns each time a non-priced event occurred (December-February 25% sell off after the Fed’s hike last year, 13% sell off after Brexit news…). It now stands at the same level of the QE announcement in January 2015 (see chart 4).
We think that the first scenario (widening spreads between Italy and Germany and political uncertainty rising in Europe) is the most probable one. we would keep a downside view on the Euro ahead of the Italian referendum with a potential first target at 1.08.
Picture 1. History map of the European Treaties and Communities (Source: Wikipedia)
Picture 2: Exchange-rate regimes for EU members starting 1979 (Source: Wikipedia)
Chart 1. EURUSD historical monthly candlesticks (Source: Bloomberg)
Chart 2. ECB (white and blue line) versus Fed (yellow line) balance sheet (Source: Bloomberg)
Chart 3. ECB balance sheet (White and Blue line) overlaid with 5Y5Y forward inflation rate (Yellow Line) (Source: Bloomberg)
Chart 4. EuroStoxx historical daily prices since QE announce (Source; Bloomberg)
Chart 5. German versus Italian 10-year yield spread (Source: Bloomberg)
Figure 1. Libor and Dollar swap yield premium (Source: BIS)
Figure 2. Weekly purchases under the expanded APP (Source: UBS, ECB)
Appendix 1. EZ (top) and US (bottom) current accounts (% GDP) (Source: Trading Economics)
Appendix 2. FedWatch Tool – Probability of rate hike in December (Source: CME)