May 7, 2012

Will Election Results Push Euro Down to Its Fair Value?

Jim O'Neill of Goldman Sachs says a drop to 1.20 euros to the dollar is more likely than not

Jim O'Neill, chairman of Goldman Sachs Asset Management. Jim O'Neill, chairman of Goldman Sachs Asset Management.

Writing before the results of Europe’s recent push left at the polls, Jim O’Neill, chairman of Goldman Sachs Asset Management, asked Friday: if the “fair value” of the euro is 1.20 to the U.S. dollar, “what on earth is the euro doing trading at a premium, which for much of the year has been close to 10%?”

In O’Neill’s view, the euro may continue to trade in a 1.29-1.35 range for quite some time. Yet, it increasingly seems to him “that 1.20 is eventually more likely than 1.40.”

Over last week, the euro declined slightly, from about 1.325 to roughly 1.320, in anticipation of the elections and persistent debt issues. Over the weekend, France, Greece and even Germany ousted candidates who supported austerity and opted instead for messages advocating growth. By late Monday afternoon the euro had fallen further to 1.305.

In France, the Socialist candidate, Francois Hollande, unseated President Nicolas Sarkozy, making him the first president in 30 years to fail to win re-election. "At the margin, his appearance on the scene is probably not a EUR/$ positive," O'Neill said of Hollande in his online column “Is the Euro Finally Ready to Decline to Fair Value and Beyond?” which he wrote before the election.

The Greeks gave a surprising vote to the Syriza party, whose name means "Coalition of the Radical Left," putting them in second place over the Pasok party, whose leader helped negotiate the country's second bailout package. If the governing coalition proves fragile, the markets could begin to factor in the possibility of Grece leaving the euro. "Presumably, at least in the short term, this may be euro negative," O'Neill wrote, but "perhaps the markets might regard an exit as euro positive."

German voters in the northern state of Schleswig-Holstein repudiated Chancellor Angela Merkel's Christian Democratic Union, which suffered its worst showing there in 50 years.

“As with many of the other considerable EMU dilemmas, it appears that the equilibrium value of the euro for Germany and others is not the same as it is for many of the Mediterranean members,” O’Neil wrote.

Goldman Sachs’ research, he says, broadly suggests that Germany can compete at a higher exchange rate than many of the others states. "In this context, a 'spread' of 1.00 to 1.35 is not an unreasonable range," he says.

O’Neil also thinks that we may want to “increasingly think of the EUR/$ rate as sort of a ‘Deutsche Mark plus’ exchange rate.” He asked, "Does this mean that for other EMU members to stay the course, they are going to have to simply live with German standards whatever the strain?”

While an exchange rate represents the relative price between two countries and market commentary, the current euro-dollar rate could be ignoring the fact that the euro is being traded against the currency in which the Fed appears to have a persistent promise of more quantitative easing.

But if fears of contagion from Greece grow again in Europe, the Fed may not be immune. "A prominent U.S. thinker remarked at our GSAM Growth Market Summit that the Italian bond yield represented the biggest re-election risk for President Obama," O'Neill wrote. "It would be ironic, if not improbable, that a major escalation of euro area financial contagion influenced the Fed more than the ECB."

In terms of more “basic” issues at play, the Euro’s does continue to be based on an underlying but small surplus.

“It may be the case that in the future, only those that can live with the stringency of the conditions required to keep the show on the road will be in the euro,” O’Neill said.

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