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Euro will bounce back – it’s just a question of when

Peter van der Welle Over the longer term, exchange rates tend to revert to equilibrium based on differences in levels of inflation. On the basis of this trend, Peter van der Welle, strategist at Robeco, predicts that the euro will appreciate versus the dollar and the pound and fall against the yen.

Speed read:
  • Fundamental models are not good at predicting currency movements
  • Exchange rates have the tendency to revert to equilibrium based on PPP
  • Based on this model, the euro is undervalued versus the dollar and the pound

There are different methods for making a prognosis for the movements in this market. “In the 1970s, various fundamental models were developed based on differences in money supply, real incomes and interest rates”, explains Van der Welle: “However, according to a study by Mees-Rogoff from 1983, their predictive power was no greater than the random walk model. This approach is also referred to as the ‘drunkard’s walk’ and current users of this model include the IMF, the World Bank and the OECD.”

The random walk theory assumes that markets are fully efficient and that all available information about the future is already factored into current exchange rates. According to this model, current exchange rates are the best predictor of future exchange rates. In financial-market practice, a model based on interest-rate parity is more often used. The core of this is that exchange-rate movements are a reflection of the differences in interest rates between countries. The currency of a country with relatively high rates should depreciate.

The random walk is unsuitable for predicting exchange rates for a period of five years as markets are not completely efficient, while a standard interest-rate parity model is not up to the job as it gives a skewed picture of expected exchange-rate movements. In this study, Van der Welle has focused on deviations in relative purchasing power parity (PPP). This theory assumes that over the longer term exchange rates move in line with the inflation differentials between countries.

Reverting to equilibrium
“First of all, to discover what equilibrium is for exchange-rate ratios of the euro with the US dollar, Japanese yen and British pound, we have analyzed historical inflation differentials in the DMS database since 1900,” explains Van der Welle: “Price movements in currency markets over the short term are much more volatile than the underlying differences in inflation, but over the longer term, they commonly revert to equilibrium.”

‘The dollar rally is coming to an end’

Deviations from this equilibrium are reflected in the movement of real exchange rates. Van der Welle discovered that these deviations in real exchange rates often revert to the equilibrium situation within five years, bringing them back into line with inflation differences: “You could compare this concept with the Shiller PE for equities. An above-average real exchange rate is an indication of an overvalued currency and an expected decline in the nominal exchange rate over the medium term.”

Research by Rogoff from 1996 indicates that it takes an average of three to five years before half the deviation from the trend has reverted. A new estimate for the US, Japan and the UK suggests that it is more like 2.5 years. “This makes it a good starting point for assuming that exchange rates revert back to trend over a period of five years”, says Van der Welle: “If we use this position to predict exchange rates, it turns out that the model’s returns explain 68% of the variation in exchange-rate ratios between the euro and the dollar.”

Euro will bounce back – it’s just a question of when 

The predictive power of this model is much higher than for the approach based on the random walk theory of interest-rate parity. “On the basis of a return to equilibrium, over the coming five years the euro will appreciate versus the dollar and the British pound,” Van der Welle predicts “The dollar rally will end and the euro will decline in value versus the yen.”

Peter van der Welle

Strategist
"Applying the right filter to the available market information is vital in our profession: What is a signal and what is noise?"
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Peter van der Welle
Strategist


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