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Tuesday, May 27, 2003

Euro Musings-The Euro hit record highs against the US dollar today; the record was set on its launch date and went downhill thereafter. My question is why? There are a few factors that come to mind. The rebuilding of Iraq will require an outflow of US dolars, increasing the supply of dollars. A decrease in the price of dollar-denominated oil will have decreased the demand for dollars. Short-term interest rates are higher in the Eurozone, for the Fed Fund rate is at 1.25% and its European equivilent is at 2.5%. That will mean short-term investment money will flow towards Europe. This would be a good time to short the Euro, if you were one to play the currency markets. The European economy will be hurting from the strong Euro, for exports will start to decline. A stagnant economy on the continant makes an Euro interest rate cut likely. As Eurozone interest rates drop, short-term money will flow back to the dollar and the underlying economic problems of the Eurozone will make it hard for the Euro to stay at this rarified level. The core of exchange rates is American demand for European stuff (goods, services and investments) that determines demand for the Euro vis-a-vis the dollar and European demand for American stuff that determines the supply. With a stagnant economy, there will be fewer and fewer goods to buy and a high exchange rate will increase their cost to American consumers. As a high-tax, high-regulation EU gets in the way of growth, investments in Eurozone companies would be hard to justify. That will lower the demand of the Euro; it will also increase the supply, as Eurozone investors look to a freer US economy as a better place to invest. The Eurocrats can have their bragging rights for the moment, but reality will sink in shortly. The long-term dynamics of the Eurozone economy will make the Euro very hard to keep at its current levels.

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