Is the Euro Overvalued? (page 1 of 2)

DailyFX Fundamentals 07-22-08

By Kathy Lien, Chief Strategist of DailyFX.com

The three Ps lifting the US Dollar

The US dollar has strengthened against all of major currencies thanks to three Ps - Paulson, Plosser and the price of oil.

US officials were out in force this morning talking up the greenback in hopes of turning it mighty once again.

Treasury Secretary Paulson said that 'a strong dollar is really very important' while Fed President Plosser called for the Federal Reserve to raise interest rates 'sooner rather than later.'

Plosser has traditionally been more hawkish than his counterparts, but it was interesting to hear him say that the Fed shouldn't wait for an economic turnaround to raise interest rates.

Although the Fed is still stuck between a rock and a hard place, their predicament is becoming a lot easier as oil prices continued to fall.

The greenback gained momentum as oil prices dropped below $126 a barrel intraday. Since last Monday, crude prices have fallen 14% to a monthly low.

If oil prices reach $100 a barrel, half of the Fed's problems would be solved; Consumers would become more liberal with their spending while businesses would become more optimistic.

For companies like American Express, more liberal consumer spending is exactly what they need. According to last night's earnings report, the bank's most affluent cardholders spent less on discretionary purchases in the second quarter.

However despite the drivers for today's dollar rally, there is still cause for concern. Oil at $126 a barrel only provides temporary relief for US consumers, but pending layoffs and credit card delinquencies suggest that consumer spending could still falter.

Wachovia and United Airlines have announced combined layoffs of more than 13,000 employees. The greater the number of layoffs, the less willing consumers will be to spend.

The rally in the US stock market has been very impressive, particularly in the last half hour of trading.

As we have said in Friday's Daily Fundamentals, it is a new week but the same drivers. Stocks and oil will continue to have a big impact on the price action of the US dollar. However keep on an eye on tomorrow's Beige Book report, which will shed more light on how the Fed districts are doing.

Is the Euro overvalued?

The Euro has weakened against the US dollar despite hawkish comments from ECB officials.

Bini Smaghi and Liebscher are the latest monetary policy committee members to support higher interest rates.

According to Bini Smaghi, interest rates are in no way restrictive since inflation is at 4% and will probably stay above 3% for a few months.

Liebscher agrees that inflation is a cause for concern which suggests that for the ECB, another rate hike could still be on the table.

In their eyes, a stronger Euro could actually help rather than hurt current conditions - granted of course their priorities are on inflation.

Experts like John Lipsky the deputy managing director at the IMF however is becoming increasingly concerned that the euro is now overvalued while the US dollar is closer to its medium term equilibrium.

According the Economist Magazine's Big Mac Index, Lipsky is right. As of July 2, when the EUR/USD was trading at 1.5885, it was calculated to be 22% above its fair value.

The currency that is most overvalued is the Icelandic Kronur at 123%.