Currencies and Candy

The falling euro appears to be the primary culprit for yesterday’s market jitteriness and clearly seems headed for ‘parity’ with the US dollar, which means an exchange rate of 1:1 between the two currencies.

The euro traded at 1.2 US dollars per euro at the beginning of the year and now trades at around 1.07 dollars per euro. Moving to a dollar per euro would represent a 20 percent decline for the euro versus the dollar.

Since thinking about exchange rates doesn’t come naturally to most people (including me, a former currency trader), let’s look at a quick example to examine the impact of shifting currencies.

Imagine that you bought your spouse some fine Belgian chocolates for Christmas and they cost 10 euros. At Christmas time, those chocolates would have cost you $12, but today the same chocolates, assuming they still cost 10 euros now only cost you $10.70 and may only cost you $10 in a few weeks or months.

There are two factors weighing heavily on the falling euro/rising dollar and they are both related to central bank activities.

In the Eurozone, the European Central Bank (ECB) has just embarked – this week – on a massive bond-buying program, known as quantitative easing. Long time readers will know that the Federal Reserve was on a similar binge that just ended last year.

The ECB bond purchases have pushed yields even lower (to less than zero in some countries), which has, in turn, made owning euros less attractive.

Since owning currency alone over the long term has an expected return of zero, investors rely on the interest, or carry, to earn a positive expected return from cash outside of their own currency.

That explains the weakening euro, but it also explains the strengthening dollar because, here at home, the Federal Reserve is getting ready to raise interest rates, probably this summer.

For a long time, there was a debate about when the Fed might raise short-term interest rates, but with last Friday’s solid (but not perfect) unemployment report, a June rise is the current market consensus.

That means that the dollar is attractive for the exact reason that the euro is unattractive: rising interest rates.

Why does the stock market care? Because a lot of large US companies earn a substantial amount of their profits overseas, particularly in Europe.

Remember that Belgian chocolate maker and how happy you were to buy chocolates for your spouse at $10.70 versus $12? Hershey (not a fine chocolate, but maybe some liberated Europeans might still have memories of GI’s handing them out) has the exact opposite problem.

A Hershey bar in France may have cost one euro at the start of the year. Holding all other factors equal besides currency changes, that euro can’t buy a Hershey bar anymore: it now costs 1.12 euros.

US products sold overseas are now 12 percent more expensive than they were less than three months ago and everyone believes that they will go higher, hurting sales further.

On a semi-related note, I realized that I wrote an article talking about multinational companies a few months ago and used Nestle as my example company.

It was only as I reread today’s post that I realized I’ve used confection companies twice to make a point in as many months. I obviously have a sweet tooth. Perhaps a forthcoming article will look at commodities with sugar as example.

Oh boy, that’s not healthy.