The pernicious effects of an overvalued euro

The euro currently trades at around $1.40, recording highs since 2011. So far this year, the currency has increased by 1.5%, and it has risen by 15.5% since the summer of 2012.

The strength of the euro is now having an impact on the economic activity. A strong euro reduces the price of foreign purchases and also reduces the oil bill; however, it increases the deflation risk and has pernicious effects on growth.

The Governing Council of the ECB will meet on Thursday in Frankfurt while the markets are waiting for definitive measures against the low inflation and the exchange rate. It is obvious that we are talking about a key meeting for the future development of the European currency.

Lowering interest rates or making the marginal deposit facility negative are decisions that may have an immediate impact on the bond market and the equities, but less so on currencies.

The euro/dollar exchange rate depends much more on what Mr. Draghi says about a possible purchase of assets and on what the Fed does with the interest rates of the federal bonds.

Market watchers don’t think that the ECB will approve the purchase of assets, but they don’t rule out the possibility of doing so in the future. If Mr. Draghi gives a sign in this direction, the European currency will be the great beneficiary: its price will tend to fall because of the quantity of euros in the markets after the purchase of assets.

There are other pernicious effects of the interest rates that are equally important but less taken into account. For example, the appreciation of the single currency versus the green banknote assimilates the companies’ profits that obtain a large part of their revenues outside the Eurozone.

Furthermore, many firms prepare their budgets according to estimates of the exchange rate. In this case, most analysts expected an euro/dollar exchange rate closer to 1.30 than to 1.40 for 2014.