New research shows the Euro-to-Dollar exchange rate is liable to shoot above its fair-value level over coming months, and stay overvalued for a considerable period of time.
Just how far can the ongoing appreciation of the single-currency extend before it starts looking too rich?
Studies conducted by UniCredit Bank shows the fair-value, equilibrium level for the EUR/USD exchange rate should lie in the vicinity of 1.24 which suggests that current levels around 1.19-1.20 indicates further work can be done by markets.
The rally in the Euro over recent months could therefore be justified if we consider the EUR/USD exchange rate had experienced an undervaluation of 16% in December 2016.
With EUR/USD around 1.19-1.20, the gap has closed substantially and the undervaluation of the rate is now considered to be in the region of around 4%.
The question to ask is what does this mean for the Euro going forward? Will the exchange rate settle around the 1.24 mark or does it shoot above and enjoy a prolonged period of overvaluation?
Analyst Vasileios Gkionakis at UniCredit Bank in London warns the latter scenario is most likely at this juncture.
It is observed, "there is a clear tendency for the exchange rate to overshoot fair value and remain above it for at least 10 months."
This figure can however be considered very conservative as it is based on the overvaluation cycle of 2009-2010.
Averaging over all cycles, overshooting has historically remained in place by more than 20 months.
UniCredit ascertain fair-value using their proprietary Behavioural Equilibrium Exchange Rate model (BEER).
The model derives fair-value by estimating panel data for G10 and CE3 currencies based on relative terms of trade, relative investment (as % of GDP), yield and inflation differentials.
The model shows that estimates of fair-value in EUR/USD have increased over the last two years.
“Between 2Q15 and now, our estimate of EUR/USD equilibrium value has risen by 4.3%, from 1.19 to 1.24. Although this “five-big-figure” increase is not unprecedented, it is still quite a meaningful change for such a slow-moving time series,” says Gkionakis.
Data do seem to suggest to UniCredit that more profound undervaluation is associated with greater overshooting.
For example, the sizeable undervaluation of 1999-2003 was followed by prolonged overshooting that culminated in overvaluation of 20% in 2008 (with a temporary local peak at around 14% in 2004).
After that, undervaluation cycles that troughed at an average of -7.3% were followed by overvaluation cycles that peaked at an average of 10.4%.
Above: EUR/USD overvaluation cycles
Gkionakis has conducted an in-depth study into the Euro-Dollar’s relationship with fair-value, and notes, "EUR-USD tends to overshoot equilibrium and remain above it for a considerable length of time. This occurred in all other four overvaluation cycles that we have identified since the Euro’s inception."
Assuming EUR/USD converges towards its current fair-value estimate over the next few quarters, UniCredit’s historical analysis and calculations show that it could overshoot by 12%, sending it to over 1.35 by mid-2019.
However, a word of caution.
A rise in the Euro might push down the level of fair-value - this makes sense as the Eurozone’s terms of trade would deteriorate as Eurozone goods and services become more expensive on global markets.
Thus, this is not an exact science.
"Our investigation takes everything else as given i.e. we abstract from any type of shock. For example, if currency strength starts weighing meaningfully on growth and/or inflation prompting a response by the ECB, the trajectory would materially shift downwards, or even reverse," says Gkionakis.
Regardless of the short-comings, the research is yet another addition to the view that the Euro is going higher and the this cycle of appreciation is not in danger of fading.
Furthermore, the exchange rate will likely stay at levels the European Central Bank and Eurozone businesses find uncomfortable for some time.
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