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Prospective Capital Flows and Currency Movements: U.S. Dollar vs. Euro Essay

This case revolves around fictional foreign-exchange strategist named Luke Anthony, as he attempts to predict the likely future path of the dollar/euro rate. In order to come to this hypothesis, the reader is presented a slew of financial information, ranging from detailed capital flows, interest rate differentials, and recent central bank press releases. This data in turn must be must be analyzed and synthesized in order to develop a proper thesis on future exchange rate pricing. To compound matters further, the evidence is no way clear cut, with some factors pointing towards a resumption of the Euro’s upward march, but others seemed to favor the dollar.

While a large variety of variables can potentially impact currency movements, the cases focuses primarily on the correlation between currency movements and capital flows. As such, filtering the evidence will require both standard thinking on FX markets and an analysis of past and prospective international capital flows. In terms of structure, we will begin by our review by assessing the types of capital flows, describe the variables/trends affecting each, and conclude with the final prediction (up, down, sideways).

In terms of standard thinking on FX markets, A historical review of the Euro and US dollar relationship reveals 3 primary scenarios, the initial strengthening of the dollar on the onset of the creation of the Euro (99-00), a subsequent multiyear strengthening of the Euro through April 2008 (01-08), save for brief pause in 2005, and a choppy phase from 2008 to the present (Graph Below). Many factors were thought to have weighted the dollar during the second phase, including the interest rate differentials and the U.S current account deficit.

On the issue of capital flows, our primary assertion revolves around the positive correlation between increased capital flows into a country and the associated strengthening of said country’s currency (specifically as it pertains to the Dollar/Euro FX rate, trading at USD 1.35 as of Feb 2013). Capital flows specifically refers to the process of money (capital) moving from one jurisdiction to another, with this movement happening via 4 primary mechanisms: 1. Flows chasing higher short- to medium-term interest rates (Fixed Income) 2. Flows to invest in equity markets that would likely outperform (Equity) 3. Flows associated with foreign direct investment (FDI)

4. Flows associated with potential reserves diversification (Central Banks)

These 4 mechanisms are all influenced by several variables, including inflation, unemployment, GDP growth, monetary policy, political uncertainty, and tax holidays; which are in term acted upon by central banks, investors, and multi-national corporations.

Central Banks (FED & ECB)

While inflation does not typically affect exchange rates, except for extreme situation, in the short-to-medium term; however, their response to inflation (known as monetary policy) can affect rates by artificially modifying interest rate differentials. Given that current policy is already factored into current FX rates, a focus on when the FED and ECB will alter policy is necessary in predicting associated changes in capital flows.

In order to better understand the policy decisions of these 2 organizations, it’s important to factor in their varying organizational mandates. While both organizations primary responsibility revolves ensuring inflation is maintained at a reasonable level, the FED (unlike the ECB) has an additional mandate of fostering maximum employment. Additionally, while the ECB HICP inflation, the FEB considers Core inflation (excluding food and energy prices).

This differences in metrics and mandate between the 2 central banks can result in diverging monetary policy stances, and as such interest rate differentials, as took place during the summer of 2010. At the time highlighted during the summer. At the time, REB Chairman (Ben Bernanke) indicated QE2 was coming, while his counterpart at the ECB (Jean-Claude) began talking inflation risks. The result, diverging 2 year treasury yields and a weakening dollar (as seen below).

What’s interesting here is that as of early 2013, the Euro Zone’s 2 year treasury yield again increased sharply, indicating the market is worried about tightening; however, the current ECB president (Mario Draghi) has yet to make any pronouncements hinting as such. In trying to understand this divergence, its important to assess the current inflationary environment. While the U.S. Core inflation index has continued to stay under 2% YOY, the Euro Area HIPC Inflation number has continued to hover at an elevated level, even as energy prices have been relatively stable (~$100/b).

Even though most of the data hints to the ECB needing to increase rates to offset inflation risk, it should be noted that the U.S. economy has shown signs of improvement. With Europe further behind in terms of recovery (and some peripheral countries still addressing default) and the US economy signaling things are improving (a point which will be brought up again when reviewing investor behavior), the risk of the FED reducing its bond repurchasing “the taper” is potential imminent (resulting in a negative impact on the interest rate differential); however, during 2013, the majority opinion of the open market committee participants tends to point to a low federal funds rate for an extended period of time, as noted in the below graphic.

Central Banks (Other Countries)

In a slow growth environment, countries typically worry about inflationary risk, as food related riots represent a significant risk to elected officials and military regimes alike. A means to fight inflation is to tighten monetary policy, another is to stop acquiring international reserves, or begin selling those you’ve already accumulated. A review of these international reserves highlights that a large majority is maintained in U.S. dollar, as indicated in the below graphic.

Feb 2013, most countries were more worried about deflation than inflation, with global inflation down to 3%. As such, the risk of countries unloading dollars as a means to manage inflation risk seems unlikely; however, global inflation can change quickly.

Finally, while debt flows into the Euro Zone had slowed significantly due to its debt crisis, the 2011 debate on treasury defaults also had a negative effect on foreign official flows, rebounding during 2012. The question becomes whether the political apparatus within the US has learned its lesson from 2011, or whether a repeat would occur again. Poll data appears to look at a government shutdown and treasury default sits highly unfavorably with the American constituent, and as such hopefully such a disaster can be averted. The differences between the US and Euro Zone here is that the debt ceiling issues within the U.S. are avoidable, while the continued talk of bankruptcy and contagion with the Euro Zone is not going away anytime soon.

U.S. Investors

Back in 2008, U.S. investors liquidated USD 198 billion in foreign investments, bringing the money back home. This figure was in stark contrast to the previous few years in which investors purchased on average USD 300 billion annually. This change, along with the growth since then, can be seen in the below image.

Why the return of funds to the U.S. in 2008? Well given the global financial crisis which started at that point, the U.S. was seen as the safest place to keep cash, especially considering that the US treasury yield is viewed as the “Risk Free Rate” due to its perceived security. Since then, we have seen money begin to leave the U.S; however, the returns have been less than ideal. As of the end of 2011, even though U.S. investors purchased, on net, $89 billion in foreign equities, their equity position fell by almost $500 billion because of large declines in overseas equity markets. Additionally, with sluggish growth trends published by the IMF, this trend is likely to consider (image below.)

In terms of specific international country trends, China is trying to engineer a tricky transition from export- to consumer-led growth; India and Brazil face chaotic economic conditions and chronic corruption, and finally, all will have to cope with rising U.S. interest rates and protect their currency by raising rates themselves. All these trends bode worse for Europe as Europe as a whole (and Germany specifically) as it is production and exportation focused. Additionally, the U.S. new found energy independence allows it to reduce its reliance on exports, helpings its BOP data and GDP outlook. Multinationals

Multination decisions, especially pertaining to foreign direct investment, has held a strong relationship with currency values; however, this relationship has broken down as of late (per below image). The question now becomes whether this represents a temporary divergence or a “new normal”, and whether FDI flows will continue to return to the US. Considering the deferential between natural gas prices within the US and those elsewhere, we are already seeing an increase in investment in downstream refinery capacity within the US. This trend typically is followed by manufacturing due to the high energy requirements, representing a potential reversal of job offshoring in the U.S. (thanks to the new energy renaissances and self-dependence).

In conclusion, while the headlines and underlying data present conflicting messages in terms of both the Euro Zone and U.S. dollar, capital flow predictions (albeit it via fixed income, equity, FDI, and reserves) tend to point towards a strengthening U.S. dollar vs the Euro. In terms of risks, while most have been discussed during the course of this review, inflation pressure on worldwide economies, proper capitalization of European banks, risk of contagion, politically uncertain nty, unemployment, and a reduction in GDP can all have adverse effects on this prognosis.

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