Euro Weakness, Dollar Strength & Thinking About Zero

The debt problems of Greece and Portugal are punishing the euro, The Wall Street Journal reports. That’s another way of saying that the U.S. dollar is rising sharply against the euro. “”Sovereign credit worries in Europe and Japan are leading to some general risk aversion,” Michael Malpede, a market analyst at Easy Forex in Chicago, tells Reuters.

What’s interesting about the euro’s current troubles is that the currency was the darling of forex not that long ago. As the chart below shows, back in early 2008, the world couldn’t get enough of the euro, or so it seemed from a dollar-based perspective.

But currencies are a volatile beast, and so today’s accepted wisdom is tomorrow’s radical idea. So it goes in forex. The euro started out at parity with the dollar more than a decade ago; it reached roughly $1.60 about two years ago. Is it headed back toward a buck? Probably, or at least if that’s the future, it shouldn’t come as a great shock.

It’s long been standard in financial economics for thinking that the expected return on currencies in the long run is zero. But that “consensus,” which is far from universal, ends the agreement over how to treat currencies. Even for those who agree that the expected return is zero, there’s debate about whether that implies that hedge forex risk is prudent (“The Free Lunch in Currency Hedging: Implications for Investment Policy and Performance Standards“) vs. avoiding the expense of hedging (“Currency Hedging over Long Horizons“)

If that’s not sufficiently complicated for assessing forex in a strategic-minded portfolio setting, there’s the overlay issue of whether we should treat currencies as a separate and distinct asset class or not. And if we should see currencies as a equal to stocks, bonds, commodities, and real estate, should the currency beta be actively or passively managed?

Well, for now, let’s recognize that it’s devilishly hard to make money in a randomly chosen currency over the long haul by simply buying and holding it. The empirical record suggests that the long run return really is zero, as a general proposition. That doesn’t mean you can’t make money in trading currencies, or that forex-related strategies like the carry trade aren’t productive, particularly in a multi-asset class portfolio.

Meantime, no one should be shocked, shocked to find that the euro isn’t set to climb indefinitely, or that the dollar weakness of recent years, must run to zero. There’s a lot of light and heat in forex, but when the dust clears, we’re often right back where we started. Not always, but enough of the time to raise questions about the latest forecast du jour.

About James Picerno 894 Articles

James Picerno is a financial journalist who has been writing about finance and investment theory for more than twenty years. He writes for trade magazines read by financial professionals and financial advisers.

Over the years, he’s written for the Wall Street Journal, Barron’s, Bloomberg, Dow Jones, Reuters.

Visit: The Capital Spectator

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