Why the Decline of the Euro Currency is Worse Than You Think

Over the last few months we’ve seen a significant decline in the decline of the Euro against other global currencies. Even compared to some of the more volatile currencies, the Euro is considered to have underperformed on all fronts. However, as 2012 begins to shows indications that a rebound may be ahead, it is important that we begin to ask ourselves about the possibilities of a European recovery, and whether or not the decline of the Euro is a pervasive trend, or a buying opportunity.

If we look back at 2011, the biggest reason for a declining Euro was macroeconomic risk associated with the debt holdings of smaller participants in the union. While countries like Greece and Spain present significant risk to the stability of the currency itself, Germany and France have struggled to maintain a sense of order in the marketplace. However, just earlier this month we saw the first signs of sanity in the market, as a fairly successful Italian bond auction actually decreased the yield on the existing prices.

This means that investors are bidding up the price of these bonds because they have a greater confidence in the ability of Italy’s new leadership to handle its financial position. Remember, this follows a yield pricing that placed the Italian bond very close to that of the Venezuelan bond under the rule of Hugo Chavez. Essentially, the market was indifferent about whether it would rather own the bonds of Italy, or a dictator that had just moments ago nationalized a series of gold mines. Combined, all of these factors caused the Euro to fall even faster than the declining US dollar.

The important thing to remember about tracking currency prices is that they are always measured in relation to some other asset. In the case of the Euro, it is generally measured against the value of the USD. While, over the course of 2011, the Euro generally fell, the USD also fell relatively to a general basket of other currencies. This means that the Euro was losing value much faster than the conversion metric would imply, because the reference point is also declining.

Think of it as measuring the speed of jogger on a treadmill. If the jogger is running in the opposite direction of the treadmill, they will go nowhere. In our case, the treadmill is the Euro, and the jogger is the USD benchmark. If both trade at the same rate, no change occurs, even though there’s lots of movement happening. However, over 2011, we saw that the Euro was trading so fast that it outpaced the USD, and the jogger of our analogy was actually going to fall off the back of his treadmill if he didn’t pick up the pace.

I guess what I’m trying to say is that the relative declines of both currencies actually indicate an even more dramatic decrease in Euro value than the standard indicator would demonstrate. So the question for the future is one of whether or not the Euro will be able to pick up the pace to keep up with its USD treadmill, or will it fall off the back end?