The Currency Cage Match

While the world can count dozens of important currencies, when it comes to top line financial and investment discussions, the currency marketplace really comes down to a one-on-one cage match between the two top contenders: the U.S. Dollar and the Euro.

In recent years the contest has become a blowout, with the Dollar pummeling the Euro into apparent submission. Based on the turmoil created by the European Debt Crisis and the continuing problems in Greece and other overly indebted southern tier European economies, many investors may have come to assume that Euro boosters will be forced to ultimately throw in the towel and call off the entire experiment, thereby leaving the Dollar completely unchallenged as the champion currency, now and for the foreseeable future. This is a stunning turnaround for a currency that was seen just a few years ago as a credible threat to supplant the dollar as the world’s reserve.

Putting aside the fact that there are many important currency relationships besides the euro/dollar axis, economists, journalists, and investors have forgotten the 16-year history of the Euro and how the currency has survived and prospered after many had assumed it might be consigned to the dustbin of history.

The Euro was created in 1992 by the Maastricht Treaty (which created the European Union) but did not come into being as an accounting unit (not a physical currency) until January of 1999. In the lead up to its launch, many had argued that the Euro would become the heir to the rock solid Deutsche Mark, the German currency that had risen to preeminence on the back of Germany’s post war resurgence, high savings rate, enviable trade balance, and post-Soviet unification. With German bankers in a firm leadership position in the European Central Bank and the European Union, many had hoped that the new Euro would adopt the virtues of the Mark. As a result, the Euro debuted with a value of 1.18 dollars. But the honeymoon was short-lived.

Almost immediately from the point it began freely trading the Euro began to encounter severe headwinds. The Russian debt default and the Asian currency crisis in the late 1990’s caused investors to sell assets in the emerging markets and seek safe havens in the dominant economies. This provided a crucial early test for the Euro. But the new currency failed to attract much of this fast flowing transnational investment flow. On the other hand, the U.S. markets and the U.S. Dollar were beckoning as extremely attractive targets.

In the second term of Bill Clinton’s presidency, America, at least on paper, looked very strong. From 1998-2000, based on Bureau of Economic Analysis (BEA) figures, GDP growth averaged 4.4%, which is roughly four times the rate that we have seen since 2008. The expanding economy and the relative spending restraints that had been made by the Clinton Administration and the newly elected Republican Congress resulted in hundreds of billions of annual U.S. government surpluses, the first such black ink in generations. Many economists comically concluded that the surpluses would become permanent (in fact they lasted just a few years). At the same time, U.S. stock markets were notching some of the biggest gains in their history. From the beginning of 1997 to the end of 1999 the Dow Jones surged by approximately 69%. The tech heavy Nasdaq, the epicenter of the “dotcom” bubble, rallied by an eye popping 294%.

As a result, international money began pouring into the Dollar, taking the wind out of the sails of the newly launched Euro. The stretched valuations that had pushed up U.S. stocks to nosebleed levels failed to dissuade investors from piling in well into the mid-point of 2000. Not only had Wall Street spread the gospel of the new economy, where negative earnings and high debt no longer mattered, but many were convinced that the interventionist tendencies of the Alan Greenspan-led Federal Reserve would protect investors against losses.

As a result of these forces, the Euro first fell to below parity against the dollar on January 27, 2000 when it closed at 98.9 U.S. cents, a fall of 16% from its debut. After that psychological barrier was breached, the selling intensified. By May 8, 2000 the Euro traded at just 89.5 U.S. cents, an additional 9% decline in just three months. This prompted news stories like a BBC article entitled “Was the Euro a Mistake?” Top economists and investors began wondering if the new currency would last much longer.

The Euro’s reputation was further tarnished in September of 2000 when Danish voters rejected their country’s plans to adopt the Euro. The distaste shown by a small country widely considered squarely in the mainstream of Western European culture was a huge black eye for the Euro experiment. The pessimism sent the currency down another 6% in just one month following the Danish election, reaching what would become an all-time low of just 82.7 U.S. cents on October 25, 2000. At that level the Euro had fallen a full 30% from its debut valuation. It looked like game over. The Euro vs. Dollar was shaping up to be a Bambi vs. Godzilla scenario.

By the late 1990’s gold had been in a bear market that had lasted almost 20 years. As a result, investor sentiment for the metal, which had historically been considered a safe haven asset, was at an all-time low. As a result, many Europeans moved into the dollar to seek shelter instead. At that time gold was trading below Euros 300 per ounce (FRED, FRB St. Louis). Those who had exchanged their Euros for Dollars (when the Euro was 83 cents) would have seen those holdings decline by 50% over the following eight years. On the other hand gold nearly doubled in Euro terms over the same time frame. As this article is being written, gold is now trading at 1,000 Euros per ounce (even after the recent big drop) while the Euro hovers around $1.10. So Europeans who bought and held Dollars continuouslywhen the Euro hit its low in 2000 would be down 25%, but those who bought and held gold instead would have seen those holdings triple. (Past performance does not guarantee future results).

The bursting of the dotcom bubble in mid-2000 finally caused a decisive break with the investment trends that had predominated in the previous number of years (see my recent article “The Big Picture“). Just as the dotcom wealth began disappearing, taking the U.S. federal budget surpluses with it, the emerging markets began to recover, and the much-maligned Euro started getting some attention.

By January 5, 2001 the Euro had hit 95.4 cents, a stunning 15.3% rally in just over two months. And although the Euro zigzagged substantially over the next year and a half (with an early retreat in 2002, causing the Organization for Economic Cooperation and Development (OECD) to wonder whether the Euro was a “Doomed Currency“), by the second half of 2002 the uptrend was firmly in place, with the Euro reaching parity again with the Dollar by July 15, 2002, 30 months after it had fallen below that level. By April 22, 2008 the Euro traded at $1.60 to the Dollar, a price that represented a 36% increase over its debut level and a stunning 93% rally from its October 2000 low.

But when the Financial Crisis of 2008 reached full flower in August, September, and October of 2008, investors once again panicked as they had eight years before. In seeking a safe haven, they once again chose the U.S. Dollar (perhaps motivated by the low valuations then assigned to the greenback). As funds began flowing out of the Euro and into the Dollar, the Euro dropped rapidly. By the end of October the Euro only fetched $1.26, a 21% drop from its April high. But when the markets stabilized in 2009 so did the Euro. It essentially traded sideways against the Dollar over the next two years, reaching back to $1.46 by June 6, 2011.

When the European debt crisis really started grabbing headlines in 2011, with yields on sovereign debt of the so-called PIIGS nations (Portugal, Italy, Ireland, Greece, and Spain) widening to record territory in comparison to the sovereign bonds of Germany, scrutiny of the Euro came into question once again. The uncertainty over possible bailouts for European banks that were holding potentially toxic government debt was too much uncertainty for the market to handle. The pressure on the Euro was intensified by the slowing Eurozone economy. These forces combined helped to push the Euro down steadily during 2012 and 2013.

But the straw that really broke the camel’s back came at the end of 2014 when it became clear that the European Central Bank, under the new leadership of Mario Draghi, would finally succeed in short-circuiting the anti-bailout restrictions of the Maastricht Treaty and outflank the objections of the German financial and political establishment in order to bring full blown Quantitative Easing (QE) to the Eurozone. The QE program essentially involves creating Euros out of thin air in order to buy government debt and hold down long-term interest rates.

Expectations about European QE came at a time when most observers concluded that the U.S. economy was finally on track for a strong recovery in 2015 and that the Federal Reserve (which has already showered the United States with almost six full years of QE) had finally done away with the program and would begin raising rates for the first time in almost 10 years. Despite a languishing economy, the U.S. markets had once again delivered stellar returns, with the S&P 500 rising 64% between 2011 and 2014, doing so without ever experiencing a correction of more than 10%.

These movements provided a strong rationale for investors to sell Euros and buy Dollars. In the 12 months from May 2014 to May 2015 the Euro fell by about 20%. When it bottomed out at $1.05 on March 11, 2015, the Euro had fallen 34% from its peak seven years earlier. This revived the opinions that the Euro was dead and that the Dollar would be the only real reserve currency for the foreseeable future.

But what if the assumptions about a U.S. economic recovery and Fed rate hikes were wrong? Could observers be mistaken now about the trajectory of the Dollar vs. the Euro as they were back in 2000? While some had warned that the dotcom bubble of 2000 could end badly, very few understood how deeply the mania was the root of the economic expansion and how severely the final flameout would threaten the entire economy. Similarly, very few had foreseen the dangers that the housing and mortgage bubble had presented to the wider economy in 2008. The economic and market contractions in 2000 and 2008 might have been much worse if the Fed had not been able to cut interest rates by almost 500 basis points in the face of the crises. (No such options are available if the economy contracts today). In other words, complacency can be very dangerous, especially if there is no ammunition to combat a crisis if it arrives unexpectedly .

Confidence is the only thing that really undergirds modern fiat currencies. But confidence can be very ephemeral…disappearing as quickly as it arrives. The U.S. Dollar benefits from confidence that the Euro currency may just be unworkable, that the U.S. economy will continue to improve, and that the Fed will raise rates throughout the remainder of 2015 and into 2016. If these expectations are unfulfilled, there could be a Euro reversal.

When a trend remains in place for a while, people tend to think it will continue forever. When it reverses, the shock can be widespread. Just as currency speculators over-estimated the strength of the U.S. economy in 2000, I believe they are making the same mistake again today. But the U.S. economy is actually much weaker and more vulnerable now than it was in 2000. If the spell of confidence surrounding the Dollar is broken, it may also reverse the fortunes of other beaten down currencies. This could present a sea change in the global investment landscape for which wise investors should be prepared.