Stretching the Euro

The concept of fair value is a powerful one. While buying a dollar for $1.10 can work during a bubble and selling one for 90 cents can work in a panic, those trading strategies catch up to you sooner or later. If, however, the fair value of a market is indeterminable, the entire notion of buying low and selling high gets tossed out the window from a floor of your choosing.

This is the case in the currency markets, especially for the dollar/euro rate -- the source of so much tension and anxiety of late. The obvious runaway freight train nature of this trade is stretching the euro beyond its limits. Given the V-shaped reversals common in currency charts, those long the euro may wish to contemplate the wisdom of selling too soon.

Where Is Fair?

That currencies are impossible to value is a given by the dual nature of their market. They have a role in facilitating actual international trade; this accounts for maybe 5% of the volume transacted daily. But to the surprise of many who view the world through an accounting lens, one wherein various forms of cash are exchanged for goods and services, very active trade in currencies can and does occur in the absence of any underlying physical flows. This is why exchange rates and the current account deficit are so unrelated over time, as I noted here in December.

The second, and by far larger, engine of currency trading is an arbitrage between the interest rates of two economies. The central equation of this trade, known as covered interest arbitrage, contains three variables, the spot exchange rate and the two interest rates along any maturity segment of the yield curve. As we all remember fondly from our high school algebra classes, you cannot solve a single equation with more than one variable; you would need either to fix two of the variables or one of the variables and the relationship between the other two.