Eurozone chaos: Why is the Euro so resilient?

You may have noticed that the Greek issue has again risen to prominence in recent weeks.

As the Greek government seemingly attempts to honour the memory of John Nash by exploring exactly how game theory may work in practice, commentators have increasingly ‘explained’ price action in relation to Greece. Over the last week, ten out of twenty of the most read Bloomberg stories have headlines which refer to Greece in some way.

Figure 1: News of the world?

Against this background, there is a sense that many are confused as to why the Euro has held up and even strengthened versus the US Dollar.

Figure 2: Euro ‘resilience’

As human beings we want to explain these moves with stories, and if Greece is dominant in our thinking we think that these stories ‘must’ be something to do with Greece. We crowbar the Greek dynamic into attempts to explain price moves, even if this contradicts what we might have previously expected.

So where once the view was that a renewal of Greek tensions would have been bad for the Euro we now have new arguments: ‘the Euro is rallying because the ‘endgame’ is now in sight’ or ‘we have moved on from Greece as an issue, it is now ring-fenced from the rest of the Euro zone.’

There are a whole range of forces that these simplistic attempts to explain the currency moves ignore.

It may sound obvious, but currency moves are always a two-sided consideration; when we look at the very short time period over which Greece has come to dominate newsflow so completely, we can see modest improvement in the Eurozone relative to the US.

The chart below shows the Citigroup economic surprise data for the two regions. The indices show the extent to which data has come in above or below the forecasts of analysts and economists. So we can see that so far this year, Europe has been doing better than expected for the most part, and the US worse.

Assuming that the existing forecasts were already ‘in the price’ of the currency, it is the surprises rather than the level itself that should have more bearing on exchange rate moves.

Figure 3: Data more disappointing in US than Europe

Closely related to this is the fact that real bond yields prior to, and potentially exacerbated by, the Greek issue have risen by a greater amount than their US counterparts (see figure 4). Other things being equal -a very dangerous phrase- this should make Euro more attractive relative to the Dollar than it was.

Figure 4: Greater relative yield increase in Europe

So, as always, to focus on a single variable to explain a price move is often an error, which can lead to much confusion. Drawing parallels with 1994 has been in fashion in the last couple of years but it can also be done here. As US interest rates were surprisingly increased, it was ‘obvious’ that the Dollar would appreciate. In fact, the year saw the Euro strengthen versus the Dollar (see Figure 5).

Figure 5: One side of the story does not explain it all

In this case other things were not equal. What those who believed in the inevitable Dollar appreciation had overlooked was the other side of the coin. In fact, over that period the Euro zone economy was strengthening materially.

All attempts to explain the causes of short term exchange rate moves should be taken with more than a pinch of salt. We must remind ourselves that short term currency moves have a high degree of unpredictability.

This is why one of the few things we see as often as betting shops on our high streets are advertisements for forex trading platforms and spread betting, and why many of those with ‘fool-proof’ methods of making money through currency trading tend to spend their time running courses to teach others rather than retiring on their huge profits.

As always it is useful to take a look at recent moves in context. We can see that recent moves are minor relative to what has happened even over the last eighteen months:

Figure 6: Beware of noise

In this context, spending much time puzzling why the Euro has responded the way it has to the Greek issue, which itself is highly unknowable, would seem not to be the most profitable use of investors’ time.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.