Why the euro isn’t down near $1.20
October 20, 2011, 11:42 AM
Several analysts have said, throughout the last month or two, that on a fundamental basis the euro should be trading closer to $1.20, instead of around $1.37.
That discrepancy can be seen in the gap between U.S. and European bond yields, which usually is a key driver of currency markets as the gap narrows or widens in favor of one country or another. “Adjusting yields spreads for sovereign credit risk, we find the euro-dollar should trade at $1.20, said Morgan Stanley currency analyst Hans Redeker.
So what’s keeping the euro supported?
“We believe this move is driven by anticipation of banks’ preparations for the upcoming stress tests,” Redeker said
European banks are repatriating assets from abroad – to beef up their capital ratios ahead of another round of stress tests, he said. They know if they don’t have enough capital to pass the test, they’ll have to turn to “recapitalization from official sources, [which] is likely to come with unwanted regulation with respect to remuneration and dividend payments. Hence, we think banks will try to raise equity ratios without using public funds.”
“We would expect the U.S. and U.K. to be hit the hardest as European banks unwind their external holdings,” because those two countries comprise nearly half of all euro zone foreign claims, he said.
However, “we believe banks cutting the size of their balance sheets will create bearish euro second-round effects,” he wrote in a report Thursday.
- Deborah Levine
