What a Strong Euro Means for the U.S. Debt Ceiling Debate

There's a risk the greenback will "overshoot" on the downside, creating a crisis of confidence.

The dollar's weakness bears watching.

Photographer: Justin Sullivan

The euro's surge above $1.20 for the first time since the start of 2015 has captivated the foreign-exchange market. The rally has been seen as further confirmation of Europe's economic recovery after years of debt crises and political instability. The question now is whether the euro is becoming too strong and at risk of "overshooting" its long-term fair value.

The debate has become more intense since European Central Bank President Mario Draghi failed to address the euro's appreciation in his Aug. 25 speech at the Federal Reserve's Jackson Hole retreat. That led many traders to speculate the ECB is relatively comfortable with the euro's appreciation. If that's the case, then the euro may gain all the way to $1.25, which is where it was trading when the ECB started its quantitative easing measures in 2015.  

While this certainly has implications for the euro-zone economy, as a rising currency can curb growth by making exports less competitive, the bigger issue may be what it could mean for the U.S. ahead of the looming debt-ceiling deadline. The reason is, a stronger euro has come at the expense of a weaker dollar. The risk now is that the greenback may overshoot on the downside, creating a potential crisis of confidence in the world’s primary reserve currency and the government. That could complicate matters for U.S. lawmakers, as failure to raise the debt ceiling by the perceived "drop dead" date of Oct. 13 raises the odds of a technical default.

It's worth reviewing the groundbreaking paper on currency overshooting by Massachusetts Institute of Technology economics professor Rudiger Dornbusch in 1976. Dornbusch, who died in 2002, surmised that in an economy where consumer prices are "sticky" and don't move that much and monetary policy is easy, the long-term value of a currency can decline along with interest rates. In such a situation, a currency can overshoot its fair value as investors decide to move capital abroad to markets where interest rates are higher.

That's exactly what happened to the euro in 2015 when the ECB launched QE. The currency depreciated by more than 15 percent as investors shied away from the region’s negative yielding bonds and as financial conditions declined. Now, euro area financial conditions are on the rise as those in the U.S. drop, fueled mainly by a stronger euro that is attracting foreign capital and a weaker dollar. The more financial conditions diverge, the greater the chance that both the euro and the dollar overshoot.      

The Euro and Financial Conditions

Source: Bloomberg

There is another factor at play here. The purchasing power parity and real effective exchange rate models of the Bank for International Settlements and International Monetary Fund show the dollar is “overvalued” by 10 percent to 15 percent based on long-term equilibrium value. As investors recognize the extent of dollar overvaluation against the increasing the risk of a technical default due to a misstep in the debt ceiling debate, there is scope for the U.S. Dollar Index to drop to 90 or below from about 92 currently. A falling dollar could then drag 10-year Treasury note yields below 2 percent as investors price in economic weakness from a looming debt crisis.     

The Dollar and U.S. Rates Since the 2011 Debt Ceiling Debate

Source: Bloomberg

The potential for the dollar to overshoot on the downside is particularly high when short-term real interest rates are considered. As real, or inflation-adjusted, rates rose since March amid a softening in inflation, the dollar index declined. The opposite would normally happen because higher real rates tend to attract foreign investor capital and that should help a currency appreciate. Now, though, there's the potential for gasoline prices to rise because of Hurricane Harvey, which may cause short-term inflation expectations to increase. As a result, short-term real rates may decline and further weigh on the dollar just as the debt ceiling debate gets underway and tensions on the Korean peninsula increase.

The Dollar and U.S. Real Yields

Source: Bloomberg

The implication is that a euro that is too strong may take the wind out of the rally in European stocks, which could have a negative impact on global markets. Also, a too-weak dollar may spark a confidence crisis in U.S. debt that could adversely affect investor sentiment. Neither outcomes are positive but the odds are rising. The summer calm in markets that investors have become so conditioned to expect may finally turn for the worse.   

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