When a good currency is bad

Over the past few days I've been getting questions by traders about the appreciating euro and how it could be a good thing. That's a very good question and as the euro and pound sterling have rapidly appreciated against the dollar and yen in recent months I think it's important to keep a few aspects of currency appreciation in perspective. With any upside for a currency there's always a downside. For this commentary I'm going to specifically focus on the euro, but it works much the same with any currency.

1. Buying power vs. earning power

Very simply, a strong euro gives foreign importers less buying power and it leaves Eurozone exporters with less earning power. Germany is the Eurozone's biggest exporter and one of the top exporting nations on the planet. When the euro is strong, especially against the dollar, German exporters suffer from less profit and less global trading opportunities because the euro's value is too lopsided. For example, it would cost a US importer of German goods more US dollars to purchase and import those goods and this acts as a deterrent to trade. In order to attract more trade and more exporting opportunities, Germany and other EMU companies generally have to drop their prices or else they sell less product.

Eurozone exporters should be very concerned about the rapidly appreciating euro because of the fact there is still a recession in Europe and every company who imports, especially if they import to turn around to sell retail, will continue to ignore countries where they have less buying power and right now there is less buying power in Europe. US exporters should be jumping for joy by the way the dollar has plunged and I'm sure their comrades in Europe are not too happy with the euro-dollar situation. It will be interesting to see if Trichet talks the euro down on Thursday in order to take some of the pressure off Eurozone exporters...

2. Deflation

A strong currency isn't always deflationary but it is deflationary when it's negatively affecting exactly what we talked about above. When a strong currency forces a company to lower its prices in order to appease an exporter, wholesaler, retailer, or consumer, this is pure deflation. When a market or a consumer steps back and says, "No way, I'm not buying your product until you drop the price" that is deflation at its essence. Deflation exists when the combined power to purchase controls and prohibits the ability to produce goods and bring them to market at sustainable levels and steadily rising prices. Right now I see a strong euro contributing to the deflation that exists in the Eurozone even though the ECB continues to deny it.

When the consumer is strong the consumer can cancel out the deflationary effects of a strong currency because they already have a pre-programmed inflation expectation, especially when commodity prices are high, and they do not shy away from higher prices for goods and services. Right now there is no consumer and if the appreciated euro causes the consumer to further entrench this will only further exacerbate deflation in the Eurozone.

Those are two of the biggest downsides I see to a strong euro. Other downsides include making it more difficult for deleveraging Eurozone banks to handle their debts, losses and writedowns. The same is true for UK banks as the pound sterling continues to appreciate. As bearish as I am on the dollar, I'm almost just as bearish on the euro because of these factors and I believe the euro's valuations do not match it's standing against the dollar and how it trades against the dollar through the USD Index. But until the markets are forced or led into another season of risk aversion, it will be hard for the euro to depreciate against the dollar to any large degree. No matter what, I think it is very important for traders to understand some of the negative fundamental aspects surrounding a strong currency because every sovereign nation should want their respective currencies to suffer the same fate as the dollar and yen.

Trichet is quite proud of the strong euro but eventually he may be forced to talk it down to stimulate growth and to help Germany and the rest of the EMU out of its recession. An appreciating currency is very much the equivalent of higher interest rates and higher borrowing costs. Those are good things for market participants seeking higher-yields but very bad things for the overall economy that needs low interest rates and cheap money to re-inflate itself.