FT Alphaville " The euro's paradox With apologies to Russell: a stronger euro may well sit within the set of things that weaken the euro. Or, to put it even more circularly, if the single currency gets stronger, then the eurozone's economic recovery gets harder - and thus the measures that are taken, ostensibly, to shore the euro up run the risk of doing it damage by undermining its longer-term existence. Now, the concept is hardly groundbreaking, and the euro has been too strong for the periphery for a very long time, but the OMT has brought it right back into focus. As we noted before, the recent strength in the euro might well offset any indirect impact of the OMT on monetary conditions in the periphery. Bank of America Merrill Lynch's Athanasios Vamvakidis took a stab at where exactly the euro's stress levels actually lie (with our emphasis): Equilibrium estimates for the Eurozone as a whole suggest that the Euro should be about 1.25 with respect to the USD. This means that a euro stronger by about 10 percent that level could start affecting negatively the Eurozone as a whole. However, the periphery needs a much weaker Euro. Equilibrium estimates for the periphery countries suggest that, from their point of view, the Euro should be below 1.1 with respect to the USD. To be really competitive, our estimates suggest that the periphery needs the Euro below parity with respect to the USD. Now, it has been a very long time since the euro was any where near parity with the dollar: So, we may want to just limit this to the idea that a 10 per cent increase from near the $1.25 level could start negatively affecting the eurozone as a whole, and a lesser increase would still damage the periphery, albeit with a lag. So where are we now? That's the euro up 8.3 per cent against the dollar since July's low of $1.2040 to and 4 per cent from it's $1.25 level at the end of August. But most don't see this good run, accelerated by the Fed's QE3 push, lasting for too much longer - Spain or Greece are bound to focus people's minds on the multiple negatives out there at some stage. Jens Nordvig at Nomura argues that even if some of the euro's tail risks have been reduced by the ECB's OMT, a risk premium on the euro will continue to be required in coming months linked to remaining uncertainties about the effectiveness of the OMT programme itself as well as the ever-present political risks. Without that risk premium, he thinks the current cyclical conditions in the eurozone may warrant a $1.35 level. But, says Nordvig: In order to for us to project a substantially higher EUR/USD rate, we would need a combination of the following: (a) a more convincing compression in eurozone risk premia, (b) evidence that cyclical conditions in the eurozone are improving (i.e. growth is returning), and (c) evidence that global capital flows are pointing to more persistent dollar selling. We don't see any of these conditions materializing in the coming months. And he thinks that while the required euro risk premium will be smaller than at the peaks of tension near the end of last year and in May of this year (when it is likely to have reached more than 10 per cent), it should remain significant, perhaps in the region of 5 per cent: That, says Nordvig, would be consistent with the euro settling around $1.27 by year's end, a figure which is in line with a lot of other guesses. Chris Walker of UBS, for example, put the euro at $1.25 at the start of 2013. Which is good news, as it goes. Extending this logic, what might be really nice is a policy option which built confidence in the eurozone's existence whilst weakening the euro and bolstering the economy. From Simon Derrick at BNY Mellon: If I were at the ECB I would be wondering if there were a policy I could use that would likely weaken my currency while, at the same time, providing support for sovereign bond markets/easing monetary conditions in the peripheral nations. Perhaps something other central banks had done recently.... And we're back in the trenches. Related links: QE would be right for Europe, too - Wolfgang Münchau A currency war campaign plan for the BoJ - FT Alphaville This entry was posted by David Keohane on Wednesday, September 19th, 2012 at 18:20 and is filed under Uncategorised. Tagged with currencies, Dollar, euro, fx.