How High Can The Euro Rise?

by John Mauldin

The euro was launched Jan. 1, 1999 at 1.21 to the dollar. It “promptly” (over a few years) fell to a low of $0.82. Today it is at $1.27 and change. The British pound and the Swiss franc have traded roughly in concert with the euro. I have been in London, Paris and Geneva this past year. I am amazed at the prices of ordinary items in terms of dollars. I wonder: How can people afford to live? $25 to take a family of four to McDonalds? $2 cokes in the stores and $6 cokes in the hotels in Geneva?

Yet, the “locals” don’t think much about it. In terms of their currencies, there has been little inflation. Things roughly cost the same as they did a few years ago. While we have seen gold go on a tear in dollar terms, there is no bull market in gold in Europe.

Our trade deficit is far higher than it was almost three years ago when the euro started to rise. Can the euro rise another 50%? I seriously doubt it. Such an imbalance in the world would reap a harvest of trouble.

It could rise another 20% to above $1.50. While a long way from $0.82, in one sense, this would not be far from the value of $1.21 that the European Central Bank originally placed on the euro.

In the last three years, the euro has done the heavy lifting of dollar devaluation. China has helped not a whit. Japan has protected the yen, aggressively buying dollars. The rest of Asia has followed suit, making sure their products would not be at a disadvantage to the American consumer. It is called competitive devaluation and has been the dominant theme in the currency markets for many years.

How long can the dollar go sideways or avoid another significant drop? As long as China, Japan and the rest of Asia continue to want their currencies in rough balance with each other. And that might be a long time.

I still believe the lynchpin is China. When they decide to allow the Renminbi to float, then other Asian countries will follow. It will not be smooth, as one can make a case that Chinese citizens will actually want to move some of their money abroad and will buy other currencies. But over time, the dollar will head south and balance against the Chinese currency.

The longer the current competitive devaluation scenario continues, the greater the problems for Europe and countries which hold to a sound monetary practice. Not only do they see their American competitors get a currency advantage, they lose “share” to Asia as well.

Supposedly, the Chinese are set to float their currency in 2007 due to a World Trade Organization treaty. In global terms, that is almost tomorrow. The prediction is that they allow the currency to float in “bands,” controlling the movement and hopefully keeping it from becoming too volatile. (I say supposedly, because I do not think the Chinese will do anything they feel is not in their best interest.)

Things may be changing. The Korean Won has risen 6% this year, the second best currency against the dollar in the world. Canada is #1, barely nosing out Korea.

And another interesting sign that has not been picked up on in the western press, but I think is quite significant. Everyone knows that China raised its interest rates this week, as part of an effort to slow the economy and bring it to a soft landing rather than waiting for the usual boom-bust cycle. Oil fell quickly, as oil traders believe this means less demand from China. That will not be the case, but that’s a story for another letter.

All of this is going to be a long process. And for that we should be grateful. The longer it takes for the world to re-balance from a U.S.-centric world where we are the main economic consumer engine to one where consumption and growth are more evenly balanced, the better.

Long-term currency moves are not one-way, and they can be quite volatile. While I am still reasonably confident that the dollar drops over the next few years, there will be more years like 2004 in front of us. I would not be surprised to see the euro go back to $1.20 before it gets to $1.40. These things ebb and flow.

Speaking of ebb and flow, the dollar is not on some permanent downward path. It will find a bottom, probably ridiculously low, the trade deficit thing will get sorted out and then the dollar will start to rise. As an example, I think Europe has more long-term structural problems than the US (I am speaking in terms of decades, not years) and would not be surprised to see the dollar and the euro at parity in 10-15-20 years. The more things change…

Where is the fly in my projection ointment? The one thing I worry about is that there is something “new” happening – a fundamental shift in the nature of how the world works. For instance, something on the order of an Industrial Revolution. Such a structural change is usually not apparent until after it has developed.

We don’t think of trade deficits between California and Alabama, or Texas and Oklahoma. Or between Perth and Sydney or Yorkshire and Wales. Yet there must be. They are just not relevant. We are a long way from the time when the world is so globally linked that such thoughts are an anachronism. But it is happening faster than most of us imagine. What is the tipping point? Such an event will mean deep structural changes, and I believe a loss of control by central banks, which is a good thing.

Of course, my dollar scenario is good for gold and other commodities. But we will deal with that at a later time.

John Mauldin is the creative force behind the Millennium Wave investment theory and author of the weekly economic e-mail Thoughts from the Frontline. As well as being a frequent contributor to The Daily Reckoning, Mr. Mauldin is the author of Bull’s Eye Investing (John Wiley & Sons), which is currently on The New York Times business best-seller list.