Why the Euro Just Can't Find Its Stride


Beaten down so many times in the few years since its birth, the euro is the currency investors love to hate. And with Continental markets in a descent reminiscent of the the Nasdaq in 2000, bearish thinking about the euro is even more in fashion these days among analysts. It's the only sane call to make. While most foreign-exchange watchers shake their heads in gloom, the bigger question is starting to take shape: What's it going to take get the euro out of the gutter?

Early this year saw the awakening of a brief euro rally -- at least against the falling dollar. Analysts were forecasting 100 cents to the euro by summer. False alarm. The currency hit a low for the year in recent weeks (84.60 cents to the euro), and most analysts are expecting it to test its all-time low of 82.28 cents. For Americans, a a European vacation this summer suddenly looks like a smart move.

The sad truth for the currency is that U.S. fears of recession have started to dissipate, leaving the euro with downward pressure. "The euro gets in its own way. Two years of failed rally after failed rally, any trader will tell you that's a sucker's bet," says Lara Rhame, currency analyst at Brown Brothers Harriman, who is not expecting a euro comeback until 2003.

DEARTH OF GOOD NEWS. That kind of talk is the norm, as the currency's pitiful performance holds a mirror to the region's troubles. "Our going thesis is that between now and the end of the year, the euro will remain under pressure," says Jay Bryson, global economist at First Union. "You may get a bounce if it hits all-time lows. I wouldn't touch it right now."

Other drags are weighing on the euro: stubborn questions about the credibility of the European Central Bank (ECB), inflation worries, and waning Continental growth. "We've been living in an environment where the euro has been a constant sell. To become bullish, we would need a string of good news," says Jeremy Hawkins, chief economist for Europe at Bank of America.

Happy news in Euroland could be hard to come by. Analysts have pared back growth expectations for key countries among the 12 members. The biggest economies are struggling, casting doubt on the region's ability to meet its target GDP growth of 2% to 2.5% this year.

First-quarter numbers weren't encouraging. Germany, which accounts for some 40% of the region's economic output, is growing at a paltry 1.6% annual rate, and many are losing hope that the country can hit its 2% growth target for 2001. Growth also appears to be contracting in France and the Netherlands, Nos. 2 and 3 in the region. But the Continent may still slightly exceed the 1% growth predictions for the U.S. economy.

LOGISTICAL NIGHTMARE. The ECB, which has kept inflation control its top priority, has begrudgingly acknowledged the slowdown. The bank cut interest rates on May 10, though the move may fan inflation. Such a cut would have sparked a stock-market rally in the U.S., where investors still have faith that the Federal Reserve can keep the economy on track. But the ECB's decision fueled criticism and frustration instead. "A lot of decision-making in the EU is politically compromised, and any negative news coming out of Euroland is euro-negative," says Kamal Shamar, currency strategist at Commerzbank.

On top of this, the rollout of euro currency, beginning in early 2002, is widely expected to be a logistical nightmare. "If it's seen as problematic, it could put more pressure on the euro and send it to 80," Shamar says. Germany is the only country set to introduce the money on January 1, 2002. But even there, citizens confess they are nervous about the new bills and coins.

While fundamental problems within Europe weigh on the euro, the powerhouse dollar is an even heavier burden. Though Eurobonds yield better returns, investors have an unwavering trust in the dollar and in dollar-backed investments. That runs the gamut from direct investment in European businesses to indirect ones, like stocks and bonds. "Investors are still assuming the dollar is giving the best returns and will give the best returns. The dollar is being bought on that," Rhame says.

While the dollar romps ahead on confidence in U.S. productivity, doubt in Europe haunts the euro. A huge change in European thinking has to sweep the region before investors will view the region and its currency as a long-term investment, Rhame says. "It's going to take a deep shift in market psychology, in terms of finding reasons to be long [the] euro," she adds.

INVESTOR-FRIENDLY STEPS. Robert Sinche, head of global currency strategy at Citigroup, takes a similar view: Europe needs to foster a more open market climate to instill confidence. "You've got to have an environment where capital stops flowing out of Europe and flows in. That's a very hard case to make," he says.

Europe's holdup of the General Electric-Honeywell merger illustrates how daunting the region can be. U.S. regulators have given the deal a green light, while Europe still frets over antitrust concerns. "That's not the kind of development to encourage the foreign community to increase investment in Europe," Sinche says.

Europe is taking steps toward creating a more friendly investment atmosphere. France has adopted rules that allow companies to hire part-time workers, giving a boost to employment. In Germany, a reduction in tax rates for both individuals and business has been well received. European regulators are working on relaxing merger restrictions, as well.

These measures should help strengthen the euro over the long term, but analysts remain skeptical. "That's a long-term political issue. It's not clear there's anything on the horizon that tells the political leadership to act in response to what the markets have already concluded," Sinche says. Until more changes are made in tax policy, mergers-and-acquisitions regulations, and labor markets, money will continue to move away from Europe to the U.S. -- or to other countries where investors see better prospects for handsome returns.

BOUNCING OFF THE DOLLAR? Over the next six months, the euro could muster a rally if the U.S. economic situation worsens. "The only thing to help the euro would be really bad news Stateside," says Jeremy Hawkins, chief economist for Europe at Bank of America. Talk of an intervention by the ECB could give the currency a lift. And as the dollar's strength erodes U.S. competitiveness abroad, there could come a point when it will take a fall. Some expect the euro to benefit from that potential dollar weakness.

"It could be a new place for sustained investment returns someday. I think that will happen," Rhame says of Europe. "A lot of good opportunities are there, but it's going to get take a deeper shift in psychology." Meantime, the euro will continue to reflect the growing pains of a united Europe. By Amy Tsao in New York


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