Euro No Longer Cheap: Nomura

• Falling ‘fair value’ means EUR/USD is no longer ‘cheap’ 
• EUR/USD close to fair value but estimates are still falling
• Commodity prices & deteriorating trade balance are key

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The Euro to Dollar exchange rate rose more than one percent this week but was travelling in the opposite direction to declining estimates of its fundamental ‘fair value,’ many of which suggest that the single currency can no longer be considered as “cheap,” according to research from Nomura. 

Europe’s single currency climbed back above 1.07 earlier this week but many estimates of its 'fair value' now suggest that it no longer trades at a discount against the Dollar, implying that it could potentially struggle to advance further in the absence of a retreat by the U.S. currency. 

“A growing number of models suggest EUR is no longer cheap. The next time you read an argument suggesting otherwise, remember to check whether it is CPI or PPI that is being used,” writes Jordan Rochester, a strategist at Nomura, in a Tuesday research briefing.

“The sharp rise in PPI inflation in the euro area has substantially reduced EUR’s fair value estimate. Its CPI estimate of fair value has not moved as headline euro area and US CPI inflation metrics remain relatively close to one another compared with PPI inflation,” he adds. 

Source: Nomura. Click image for more detailed inspection.

There are many different kinds of financial models used by analysts in their attempts to gauge an appropriate value for a currency and to define levels at which exchange rates might be considered either “cheap” or “expensive.” 

But all of these are heavily influenced by inflation rates and this is where nuance enters the picture because some models take their cues from the Consumer Price Index rate of inflation, the measure targeted by central banks, while others are more influenced by Producer Price Index inflation.

Source: Nomura. Click image for more detailed inspection.

“When experiencing two of the biggest economic shocks in modern history (Russia sanctions and China lockdowns), maybe the output from a CPI model (which includes many services that can't be traded abroad) isn't the only metric we should use to value things,” Rochester said on Tuesday. 

“The energy crisis is a bigger problem for the euro area, which is more dependent on Russian imports of natural gas than the US. It’s not just energy, but also raw materials and food. This is why PPI inflation has risen much more sharply for the euro area than the US,” he added.

Source: Nomura. Click image for more detailed inspection.

It has often been said in recent years that Europe’s single currency is significantly undervalued relative to the Dollar and throughout that time at least some of the more popular valuation models have supported this assessment. 

But the pandemic period and Russia’s subsequent invasion of Ukraine have both been game-changers because of their impacts on prices of components and other inputs in the manufacturing supply chain as well as the resulting increases in prices of crucial fossil fuels like oil and gas. 

Source: Nomura. Click image for more detailed inspection.

These factors have led the once significant trade in goods surplus of the Eurozone to flip to a deficit, which has in turn led a once sizable current account surplus to trend lower, leaving it too in danger of turning to a deficit.

“With the collapse of the euro area trade balance, the other components of the current account can’t offset this. A combination of the current account deficit with the components of the financial account gives a lead on EUR trends and this still does not paint a rosy picture,” Rochester says.

Source: Nomura. Click image for more detailed inspection.

“Even if using trade-weighted measures for valuing EUR, incorporating the UK, US, Japan, China and many many more we reach a similar conclusion: EUR is cheap via CPI valuations but expensive if using PPI,” Rochester wrote of one popular measure for valuing currencies in overall or trade-weighted terms.

“The BIS monthly series to the 1960s suggests otherwise. Even if using the CPI as the deflator, as in Figure 10, for both the narrow and the broad series, the EUR isn’t exactly cheap,” he added.