Euro Keeps Winning the Currency Limbo Contest

Once again, it's time for currency traders, investors and government ministers to ask that now traditional question: Can the euro actually go any lower?

Every time they've asked before, the answer has been, "No, it has to find some support here." And as the following chart shows, the battered currency has then promptly headed south toward yet another record low.

Euro/Dollar January 1999 to September 2000

Source: Reuters

This week has been no different. The euro has fallen to a new low of 86.30 cents vs. the dollar, although by the close today it had strengthened a bit, to 87.30 cents.

Perhaps, then, the question should be: Can the dollar actually go any higher? That's because the main problem facing the euro since its introduction at the start of 1999 is that the U.S. economy is simply too attractive. The dollar keeps gaining on strong U.S. growth, low inflation and improving productivity.

But if all signs are positive for the dollar and the U.S. economy, the ultimate question for many might be: Why should U.S. investors care how low the euro goes?

Dupont (DD Quote) shareholders found out why earlier today when the company warned of lower 2000 earnings due to higher energy and material costs as well as the euro's weakness. With so many companies now reliant on global revenue, the weak euro often translates into diminished profits from operations in Europe.

In addition, mutual funds with European holdings are likely to suffer. This occurs if holdings are converted back to dollars, or if the European Central Bank continues raising rates, which in turn causes money to flow out of equities, which results in lower share prices.

Bad news on those fronts could cause wider pain than many expect, rippling throughout the market. And the bad news could continue, as many in the currency markets don't see the euro's fortunes improving anytime soon. Even a rate hike by the ECB a week ago failed to take the shine off the dollar. So is there nothing the euro's backers can do? There is the tried-and-failed approach -- issue a statement of confidence in the currency and hope for the best. That's what eurozone finance ministers will likely do when they meet tomorrow.

Or the ECB could decide to intervene, a possibility that is being hotly debated in foreign exchange markets. Many feel the ECB has now run out of other options. "The ECB will have to draw a line in the sand and consider intervention," says Neil Mackinnon of Merrill Lynch. "It's inevitable that intervention will come," adds Ashraf Laidi of MG Financial Group. But intervention is a risky undertaking, and it does not guarantee success. So others in the currency markets feel that the central bank should stick to its policy of "benign neglect" toward the currency.

It should also be noted that that the euro isn't the only ugly duckling compared with the dollar. The pound is at a seven-year low, the Australian dollar is at a five-year low and the Swiss franc is looking at a valuation not seen since 1989. The yen alone has kept its value and is still trading at historically strong levels.

But it's also true that the euro has its own particular problems, many of which are self-inflicted. Traders place a fair share of the blame on the ECB, which has endured a harrowing time in the past two years. In linking the economies of 11 different countries, the bank was always under pressure to get its interest-rate policy right. In addition, it needed to convey a sense of self-confidence in dealing with the complexities of the foreign exchange market. Unfortunately, it has failed to achieve both of these objectives.

By contrast, the dollar has had the backing of the highly regarded Fed Chairman Alan Greenspan . Yet another point in its favor.

And from the outset, euro rates were set low -- in line with traditional Bundesbank practice -- and have been kept relatively low ever since. Even with a 25 basis-point hike last week by the ECB, many investors think euro-denominated rates are still lackluster. "You still don't get paid for holding European bonds," said Ian Shepherdson of High Frequency Economics. He believes dollar-denominated assets are simply a better value and that the investment balance will continue to favor the U.S.

Along with a weak currency, the ECB is faced with some unappetizing choices. Eurozone economic growth is lagging that of the U.S., but inflation is now coming in ahead of the official, upper limit of 2% per year. Oil prices have risen sharply in recent weeks, representing a new barrier to growth and a threat to price stability.

European finance ministers are obviously at a loss to understand why their baby is so unloved. When the euro was first traded on international financial markets in January 1999, it was expected that the new currency would be "well bid" and that the problem of the newly established central bank would be to stop it rising above its opening-day high of $1.18.

Instead, the euro immediately began to slide. By the middle of 1999, it was already off by 14% and was close to parity with the dollar. Since then the story has continued pretty much unabated. Soon after its first birthday the euro was below a dollar. Now, it's in the 87-cent range. To judge from the comments of foreign exchange market specialists, the immediate outlook for the euro remains bleak. As perennial euro-bear Shepherdson says, "The euro needs a surprise rate hike or a collapse of the U.S. economy" to see improvement.