Hamish McRae: Parity looks right for euro and dollar, with sterling mid-Atlantic

Is it euro strength or dollar weakness? The euro's climb against the dollar – and to a lesser extent against sterling – has been the dominant theme of the currency markets this year. It has now risen to such an extent that its strength is starting to undermine the one segment of the German economy that is providing all the growth, exports. It is also having the incidental effect of increasing the relative size of the French economy so that it may soon surpass the British one, even though we have been having faster growth. It all seems a long way from the time when the sickly euro was seen as a symbol of European economic failure.

Is it euro strength or dollar weakness? The euro's climb against the dollar – and to a lesser extent against sterling – has been the dominant theme of the currency markets this year. It has now risen to such an extent that its strength is starting to undermine the one segment of the German economy that is providing all the growth, exports. It is also having the incidental effect of increasing the relative size of the French economy so that it may soon surpass the British one, even though we have been having faster growth. It all seems a long way from the time when the sickly euro was seen as a symbol of European economic failure.

But the problem with currencies is always to know what the appropriate anchor should be. A weighted average of trade gives a sort of benchmark. Purchasing power parity comparisons give another.

As there should be in all markets, there are several views. Three spring to the top of my list.

One is the "look at the US current account" view. This starts by looking at the US current account deficit, now running at some 4 per cent of GDP, and argues that the US economy has been on an unsustainable path. It has managed to sustain faster growth than the rest of the developed world but only by indulging in a consumer boom that had to be paid for with borrowed money. So what is happening now is an inevitable and necessary adjustment. For a while the higher returns in the US attracted a sufficiently strong capital inflow to cover the current account deficit but once the bubble burst this fell away. So the dollar will come down against both the euro and the yen – both the eurozone and Japan are in current account surplus – until things come back into line.

The second view is that this is more a euro story than a dollar one, "the euro's strength will return". The euro was artificially depressed after its birth, partly because of wobbly leadership by the European Central Bank but more because people focused excessively on the problems of Germany. Sure, the German economy has serious structural problems, and sure it is more than 30 per cent of the eurozone. But much of the rest of Europe has not been doing at all badly. Germany has been leeching investment, particularly to the accession countries to the east, but the rest of the zone has been doing quite well.

The third view is that this is all the effect of a probable Middle East conflict: "It is all about funk." The euro did overshoot on the way down but we all knew that. Fears that the US might get bogged down in the Middle East, or at least that the costs of the conflict might be vastly greater than appreciated, is now making the dollar weaker than it should be. Once things are clearer it will recover.

Well, what should we make of all this? The first thing to remember is that these explanations are not mutually exclusive: there is a bit of truth in all of them. But they do lead to very different conclusions. If the main story is the US current account then the dollar will remain depressed – and the euro will remain strong – for several years. If the story is that Europe's currency will match the underlying strength of its economy, then if structural reform takes place the euro will continue to strengthen – but if it doesn't the currency will fall back. And if it is all about the war, then assuming a reasonably swift and successful outcome, the dollar will recover and the euro fall back.

So which is the most important, or at least most relevant, explanation?

I was intrigued by the top graph, from GFC Economics. It plots the eurozone basic balance (ie the current account surplus plus the capital account deficit) against the dollar/euro exchange rate. Between 1998 and the middle of 2001 there was a huge outflow of capital from Europe. This flow was so big that it more than offset the current account surplus. But since then the flow has largely ceased, at least to an extent that it is more than covered by the current account. The dollar/euro exchange rate seems to be a lagged response to this.

If this is the dominant relationship much will depend on capital flows into and out of the eurozone. If there is a reasonable recovery of investment in the eurozone, in part perhaps a response to some reform in Germany, and the basic balance remains in surplus, expect euro strength to continue. If the eurozone continues to underachieve, expect the euro to fall back.

The other two graphs support the "funk money" explanation. HSBC has plotted interest rate differentials between the euro and the dollar against the exchange rate. As you can see from the middle graph there was a net fit through from the beginning of last year until last November. Then the lines diverged. If interest rates are the most important factor determining the relative rate, then expect a bounce back by the dollar to about parity. HSBC attributes this divergence to war fears.

The bottom graph looks at the performance of the US economy. HSBC has created an index of economic surprises, positive and negative. Again this fitted nicely until last November, when it started to break down. The best explanation, again, is the decline in confidence in the dollar as a result of the prospect of war.

What should the sensible outsider make of all this? My own view, for what it is worth, is that there is surely some war effect. This is a factor in the weakening of sterling too, though, as usual, the pound has tended to move between the dollar and the euro. It has, since 1997, actually been the most stable major currency in the world.

But I don't think that this necessarily means that the dollar will recover if and when it is clear that the war will, in military terms, be a success. During the Gulf War the dollar weakened ahead of the actual conflict and then swiftly recovered. But I am not sure that this pattern will be repeated. The coalition behind the US is less cohesive and the danger of further terrorist attacks more real.

On the other hand, Europe will not put in a particularly solid economic performance in the coming months. It is too dependent on US demand. While the ECB will make further cuts in interest rates, these may not do much to boost domestic consumption in Europe and of course will narrow the interest differential with the US.

My conclusion for the euro is that most of the appreciation that is likely to take place has already occurred. Were there to be some sort of disaster (from a US perspective) in the Middle East, then sure, the dollar would fall further and push the euro up. Otherwise, parity is about the right level.

And the pound? Well, we seem to be able to live with the present rate, maybe even with one a bit higher than it is now. The current account deficit seems to be narrowing, not widening. But the basic rule is and will continue to be that the pound is a mid-Atlantic currency, performing half-way between the dollar and the euro. Sort of appropriate, isn't it?