Purchasing power parity supports dollar. Purchasing power parity (PPP) posits that, theoretically, the same goods should cost similar prices, regardless of whether they are denominated in euro or dollar terms. There are many different estimation techniques and consequently many different results, ranging between EUR/USD 1.20 and 1.32. Hence, the dollar clearly appears 'cheap' and should strengthen. While low inflation in the euro zone supports the euro, inflation in the US is only marginally higher, and thus there should be no significant effect on 'fair value' dynamics.
Fed vs. ECB balance sheet: slowdown of increase in 2014 still slightly dollar negative. One of the most important factors behind the current dollar weakness appears to be the expansion of the Fed’s balance sheet (asset purchases) concurrently with the shrinking of the ECB's balance sheet (repayment of 3-year LTROs). In spite of the announcement that the Fed will taper its asset purchases and expectations of further ECB measures, this trend should only slow down over the course of the year (instead of reversing, as previously assumed). This is because the Fed’s balance sheet will grow until the end of 2014, while the ECB has barely any opportunities to strongly increase its balance sheet (since excess liquidity is in the process of being repaid at the moment). This argues for a stronger euro.
Potential end of debt crisis supports euro. Last year, the easing of concerns with respect to the Eurozone debt crisis has been surprisingly pronounced, which is likely to also have supported the euro. The correlation between high yield spreads in Italy and a weak euro is no longer as strong as it used to be in 2012. However, lower yields in Italy and Spain still argue for a somewhat stronger euro.
European equity outperformance might have supported the euro – but this is not backed by data. Since mid-September, European stock markets have rallied more strongly than US stock markets, which should have led to an increase in capital inflows. However, this was not visible in the euro area balance of payment, and therefore remains largely a 'psychological' argument - in spite of the strong correlation between relative stock market performance and the exchange rate (illustrated in chart on lhs).
Yield difference supports dollar. Higher short- to long-term yields in the US as compared to the Eurozone benchmark Germany continue to suggest dollar strengthening. Treasury investments generate a higher return as long as they do not have to be sold prematurely at possible price losses. Since the summer of 2013, the eventual end of Fed purchases seems to be priced in, however, which should limit additional price declines. Finally, the growth outlook remains clearly better in the US than in the Eurozone. Hence, US rates should on average remain higher. In the long term, this argues in favor of the US dollar.
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