The August 2007 to July 2008 euro bubble ended spectacularly. In three months of trading the united currency lost almost quarter of its value against the dollar. Valuations in bubble markets are divorced from reality, they are propelled higher by the internal logic of profit. As long as participants in the market can push prices higher then some will make money and the bubble is self-sustaining. But when the collapse comes is it swift, deep and usually irreversible. Bubble markets do not recover.
Financial market bubbles are often accompanied by a theory that explains why the unusual valuations, so different than traditional measures, are consistent with good sense. For the euro bubble the fashionable theory was 'decoupling'; the idea that American banks were uniquely infected with the sub-prime virus and that the United States economy could drop into recession but Europe and the rest of the world would sustain moderate if not robust growth. Until quite recently the European Central Bank (ECB) had ascribed to this idea, and used it to justify its July rate hike. But the bank endorsement did not give the idea any more credibility.
Peak to trough the euro lost 23% against the dollar from mid July to the end of October. It has recovered a scant 2.0% at Friday's close. Its greatest recovery, which lasted less than one day, has been 6.0%.
Since the great fall the euro has traded in a 500 point range around 1.2750. That range was last occupied between May of 2006 and the end of that November. In that period the Fed was just finishing a long series of rate hike which halted at 5.25% in mid year. The ECB was also raising but would not finish until it reached 4.0% in the early part of 2007.
The current rate situation is similar but in reverse. The Fed has orchestrated a historic 4.25% reduction in the target Fed Funds rate since last September. But Mr. Bernanke and the board are almost finished cutting, regardless of whether rates are slashed at the December 16th meeting or not. At 1.0% the Fed cannot realistically go much lower. Mr. Trichet and his bank are headed in the same direction and to a likely similar end. But, as in the 2006 period they are six months to a year behind the Fed.
In 2006 the ECB rate hikes were the new factor now the new consideration is the ECB cuts. In 2006 the US economy grew at an annual rate of 2.7% in the 2nd quarter, 0.8 % in the third and 1.5% in the fourth. The Eurozone expanded at 2.9%, 2.8% and 3.2% respectively in its year to year measure. In the third quarter of this year the Eurozone was already in recession, having fallen 0.2% in second and third quarters. Even the most sanguine market observers expect at least two more negative periods. Though the US may not officially be recessionary, having scored 2.8% growth in the second quarter and -0.3% in the third, a dismal fourth quarter is predicted. Perhaps GDP will contract by a much as 3.0% annually or more with much gloom anticipated in the early quarters of 2009.
In 2006 the six month pause in the second half of the year was only a brief stay in the euro's seven year rise against the dollar. But there is little reason to think that the dollar has begun a new long term advance against the euro with its run of the last four months. The economies of both the United States and the Eurozone are probably in for long comparable bouts of recession and low interest rates. Neither GDP growth nor central bank rate policy will provide the competing currencies with an advantage. But if we have not started a strong dollar period, there is also no reason to expect a substantial rebound in the value of the euro against the dollar. Bubbles do not recover.
The August 2007 to July 2008 rise in the euro was not part of the longer trend going back to the early years of the decade except in the sense that the prior trend gave traders confidence in the upward movement. The August inception was the product of two singular circumstances and the erroneous interpretation of one.
The first, of course, was the US sub-prime and asset backed securities debacle. The potential for disaster was correctly diagnosed by Mr. Bernanke and the Federal Reserve. It was a serious threat to the banking system and American economic growth. Even if the governors did not at the time know how it would play out they clearly saw the danger and immediately began to support the economy with lower rates. The ECB did not sense the danger. Its spokesman continued to preach the anti-inflation gospel throughout this period even raising rates a final 0.25%. And it was this ECB confidence that gave the united currency such strong backing for the entire period. If further proof is needed of the effect of the false confidence of the ECB on its currency we only need remember that it was Mr. Trichet's statement in mid July that Eurozone growth was going to be much weaker than the bank had previously predicted, that set off the euro cascade.
The second circumstance was the easy credit in the early part of the decade which contributed a great deal to the boom and now bust in the housing market. It is harder to gauge its effect on the commodity and currency markets. But the appearance of price bubbles in many commodities and commodity currencies including euro and oil, at the same time speaks of, if nothing else, a willing suspension of rationality. It is no coincidence that the price of oil and the euro reversed within days of each other. This circumstance is now ended and the analysis that justified the rise of oil and the euro now seems slightly foolish.
The euro bubble is gone, it will not re-inflate. The dollar and the euro have begun a new relationship, or maybe just renewed an old one.
