What the Euro Will Look Like in Five Years

October 3rd, 2011
in contributors

Money Morning Article of the Week

by Sean Hyman, Forex Strategist, Money Morning

Believe it or not, there was a time when investors saw the euro as the savior currency of the world.

People talked about how the euro would replace the dollar as the world's reserve currency - and there was plenty of proof to support that opinion. 

At the time, the European Central Bank (ECB) had the right monetary solutions in place to fight inflation, while the U.S. Federal Reserve was struggling to keep inflation under control. That was another point for the euro, and a strike for the dollar.

Follow up:

So not surprisingly, central banks started replacing some of their U.S. dollar reserves with euros, and the euro became a second "reserve currency" for central banks.

The euro also soared past the dollar in just a few years. In fact, the euro shot up from 82 cents at its inception to $1.60 in less than 10 years. 

Yes, it seemed that the planets were aligned for the euro to step up to the plate and become the world's reserve currency. 

But that's because the euro had never experienced a real "rough patch," or serious monetary crisis. 

Fast forward to 2008.

The Euro Gets its First Test

Once the credit crisis was in full bloom in mid-2008, loans dried up and unemployment went to 10% in the United States and Eurozone.

When crisis struck in 2008, the euro came under pressure. Germany and France could handle the issues, but the world quickly learned that Greece, Portugal, Spain, Ireland, and Italy were the Eurozone's downfall

The euro can only be as strong as these weakest links. Unfortunately, none of these weak links have recovered yet. More importantly, they are not going to recover anytime soon.

A bond crisis like the ones erupting in Greece, and to a lesser extent Portugal and Ireland, can take years to shake out. 

That's why, to this day, no matter how many loans the ECB or the International Monetary Fund (IMF) gives Greece, Portugal or the other nations in debt, they still haven't been able to fix this problem.

The European Union (EU) continues to give Greece bailout funds. But securing bailout money will not solve things. It's just a band-aid, not a cure.

The larger problem is that the ECB sets an interest rate policy that does not work for all EU nations.

Larger, more fiscally sound nations like Germany and France can handle it when the ECB hikes rates. The smaller debt-ridden nations can't. These guys are quickly finding this out now.

Here's How It All Ends Up

In the next five years, I highly doubt the Eurozone will keep all its members. It will still exist, though. The euro will survive. 

But for that to happen, it will have to purge the dead weight that's dragging it down.

In 2016, I'd say only the larger countries will still be in the euro. I have no doubt that Germany and France make the cut. They will probably find some way for Italy and Spain to stay in the euro, too. These are the largest economies (by GDP) in the Eurozone. 

Most of the smaller economies are one-third or one-fourth the size of these larger ones. I believe that most of them will be forced to exit the euro and institute another "home currency" for themselves. 

One of the only smaller countries that seems to handle the overall interest rate policies is Estonia. It has a fast- growing economy and a budget surplus. 

Aside from that, I have my doubts about most of the other smaller economies making it longer-term with the euro. (That includes the smaller Greece, Ireland, Italy, and Portugal.) 

With countries having their own currencies and central banks, when debts pile up, they will be able to simply devalue their currency (similar to how the Fed has done with the dollar). 

It's not the best solution, but it will help pay off their debts. And the smaller countries will no longer drag down the larger economies.

In the end, it will work out best for the Eurozone. However, as this process unfolds, and one country after another leaves the euro currency, it's going to destroy whatever positive sentiment is left in the euro.

That's why I see the euro/U.S. dollar (EUR/USD) exchange rate heading so much lower. In fact, I believe the euro could hit parity with the U.S. dollar in the next five years. (Something that hasn't happened since 2002.) 

As this all unfolds, there will be some incredible opportunities to short-sell the euro in the forex market, especially against the dollar. That involves short-selling the EUR/USD pair.

Bottom line: The euro woes are far from over. Over the next five years, we'll see this play out in the currency market as the euro plummets in value. As a trader, I'll certainly be looking to short the euro as it continues to fall.

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